______FWes 1122Polly Roerch

WORKING PAPERS

Public Economki

Policy Research DepartmentThe World Bank

March 1993WPS 1122

Fiscal Decentralizationand Intergovernmental

Relationsin Transition Economies

Toward a Systemic Framework of Analysis

Richard Birdand

Christine Wallich

Designing a well-functioning intergovernmental fiscal system isessential to the success of all the transitional economies' majorreform goals: privatization, macroeconomic stability, more effi-cient performance and economic growth, and an adequate socialsafety net.

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Policy R oroh|

Public Economics

WPS 1122

This paper - a joint product of the Public Economics Division, Policy Research Department, and theInfrastructure Division, Technical Department, Europe and Central Asia, and Middle East and North AficaRegions - is part of a larger effort in both departments to analyze issues relating to decentralization, andin particular, the role of subnational governments in the reform pmcess. Copies of the paper are availablefree from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Bonnie Pacheco,room HI 1-065, extension 37033 (March 1993, 85 pages).

The decentralization of government in Eastern subnational governments may look to "copingEurope represents a reaction both from below (to mechanisms" such as holding onto their enter-tight central political control) and from above (to prises (which provide vital social services),privatize the economy and relieve the central developing extrabudgetary revenues, or borrow-government's fiscal stress). ing. These coping mechanisms threaten privat-

ization, reduce budgetary transparency, andIn all transitional economies, the developing impede stabilization policies.

structure of intergovernmental relations isintimately related to such critical policy issues as Bird and Wallich describe the risks toprivaization, stabilizatic l, and the social safety piivatization, to macroeconomic stability, and tonet. In the fiscal sphere, tax reform, deficit an adequate social safety net that present policiescontrol, and intergovernmental finance are a toward local government may imply. Its themestripod. Unless each leg is set up properly, the are that the subnational sector needs to be morewhole structure could collapse. realistically factored into national plans - and

that subnational expenditures be more clearlyThe present strategy of devolving expendi- assigned and revenue needs more realistica9;y

tures downward while holding back on revenue assessed. S&ch assessments are likely tv ac-flows and transfers to balance the central budget knowledge a larger sphere for subrationalis unlikely to succeed for more than a year or governments and the need for accec! tmtwo at bestL robust revenue sources. Giving local government

a share in the personal income tax is one possibleNet spending reductions at the subnational and perhaps desirable approach to meeting these

level may be difficult to achieve. From 10 to 40 revenue needs.percent of outlays go to the subnational sector,and in many countries local governments provide Careful attention needs to be paid to themuch of the social safety that makes the pain of design and implementation of thethe economic transition politically tolerable. intergovernmental fiscal transfers likely toAnd, most housing and many enterprises have remain prominent features of thebeen shifted to local ownership, with the mainte- intergovernmental landscape for years to come.nance and subsidy cost this implies. Since the Caution is also needed on borrowing byrevenue sources assigned to local governments subnational government. Consolidating andcannot finance expected levels of local activity, integradng extrabudgetary funds at thethe result of shifting spending downward is subnational (and national) levels is crucial tolikely to be strong demands for increased, rather enhanced budgetary transparency andthan decreased, transfers. Altematively, macrostability.

The Policy Research Working Paper Series dissemirsates the fmdings of work under way in the Bank. Anobjecii vof the seriesis to get these findings out quickly, even if presentations are less than fully polished. The findings, interprAtations, andconclusions in these papers do not necessarily rexesent official Bank policy.

Produced by the Policy Research Dissenination Center

FISCAL DECENTRALIZATION AND INTERGOVERNMENTAL RELATIONS IN TRANSITIONECONOMIES:

TOWARD A SYSTEMIC FRAMEWORK OF ANALYSIS

by

Richard BirdUniversity of Toronto

and

Christine WallichCountry Economics Deparhnent

Public Economics DivisionThe World Bank

Table of ConLonts

1. INTRODUCTION AND SUMMARY . ......................................... 1

Why 8Local1 Finance Matters 1........................................... Traditional vs Systmic Frameworks . ....................................... 2Organization of the Paper .............................................. SPolitical/Overall Structural Reform Context ................................... 6Borrowing .................................................. 8Extrabudgetar Funds ................................................ 8Infitutional Framework ............................................... 8

II. DECENTRAULZATION IN PROCESS: TRENDS AND THEMES ........................ 9

A Time of Transformation . ............................................ 9The End of Centra Planning: Filling The Abhorted Vacuum ........................ 9Political D entatization . ............................................. ' 11The Size and Scope of Government: How Many Levels? .......................... 15Size of Government Units: Efficiency and Other Concens ......................... 17Supporting Subnational Government: The Institutional Setting for Subnational Governmental

Reform ......................... 8............. iThe Changing Role of Govermment: From Ownership to Servic - Provision .............. 19Simultaneous National and Integovernmental Fiscd Reforms. ....................... 23Stablizadtio: The Macroeconomic Context for D sentrizaton ...................... 24

II. WHO DOES WHAT? THE ASSIGNMENT OF EXPENDrrURES ....................... 29

The Efficiency Case for Decentralized Loca GovermenL .......................... 29Expenditure Asignment in Pratice ........................................ 29Local Public Enterprise Ownehip ........................................ 35Provision of Social Services: Shifting the Safety Net Downstain .................... 37Expenditure Assignment in Principle ....................................... 37Extabudgetary Funds ................................................ 39

IV. FINANCING LOCAL PUBUC SERVICES THROUGH USER CHARGES ................. 40

V. THE CHOICE OF SUBNATIONAL TAXES ..................................... 42

Characteristics of a Good Local Tax ....................................... 46Local Propet Taxes ................................................ 47Own Subnational Taxes versus Shared National Taxes ............................ 48

VI. THE DESIGN OF INTERGOVERNMENTAL TRANSFERS .......................... 50

Closing the Fiscal Gap ................................................ 50Equalization ...................................................... 50Fiscal Effort ...................................................... 52Matching Grants ................................................... 53Other Objectives of Transfers ............................................ 54A Case for Conditionality? ............................................. 55

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Determining the Size of the Grant . . . . . . . . . . . . . . . . . . . ... .. ........ . . . . . . . . 56Distribution of the Grant ............................................... 56Measuring Capacity and Expenditure Need .................................... 57

VII. BORROWING ...................................................... 58

Past Borrowing Pr ac tic e s ............................................... 59Sources of Borrowing ................................................. 60

VIII. PRIVATIZATION AND OWNERSHIP ....................................... 61

AssetTansfers ............................. 61Privatization vs Entrepreneuriaism .................................. 62Timing of Asset Sales: Sales vs Give-aways .................................. 63Revenues from Privatization .................................. 64

IX. CONCLUSIONS .................................. 64

REFERENCES ................. 84

List of Tables

Table I Trends in Decentralization: Government Organization. 16Table 2 Decntrlization: Scale and Size of Government ...............................Table 3 Reform and the Size of the Government Sector .22Table 4 Macroeconomic Indicatorsi.2Table 5 Tax Administration in Transition Socialist Economies ............................ 28Tabls 6 ExpenditWe Assignment to Subnational Authorities .............................. 30Tanle 7 A Possible Expenditure Assignment ....................................... 8 3Table 8 Revenue Assignments to Subnational Authorities .............................. 44Table 9 Structure of Subnational Govermment Finance . ................................. 1Table 10 Subnational Government Borrowing .......................................59Table 11 Privadzatioa Revenues: Ownership and Disposition .. 62

Acknow_edeMents

We would like to thank those who commented on this paper, or who otherwise shared their insights onsubnatlonal finance in the various countries, including Felix Jacob; Zelko Bogetdc, Robert Van Pulley, ThnCondon, Gabor Peteri, Shankar Acharya, Anwar Shah, Hen g-fiu Zou, Tony Pellegrin4 Jim Hicks, LucaBarbone, 7Thanos Cat sambas and Amaresha Bagchl. Research assistance of Rltu Nayyar is gratefullyacknowledged. Susheela Jonnakuty providedexpert word prcessing. 7Thisis the firstin a seriesof papers underRPO BB67770M.

FISCAL DECENTRALIZATION AND INTERGOVERNMENTAL RELATIONS IN TRANSIONECONOMIES:

TOWARD A SYSTEMIC FRAMEWORK OF ANALYSIS

... A chang of government is not a chang of system, merely one of the politicdl conditions forit. Tho change of system is a historical process that seer- liksely to require a long period oftime. &'

. INTRODUCTION AND SUMMARY

Why 'Local" Fimnce Matters.

1. An important and unduly neglected aspect of the process of transition in Eastern Europe is the extensivedecentralbiation, both political and fiscal, that is taiing place in many of the countries newly emerging from behindthe socialist veil. Decentralization represents both a reaction ftom below to the previously tight political controlfrom the center and an attempt from above to further the privatzation of the economy and to relieve the strainedfiscal situation of the central govermnment. The aspirations of, and the role of, local government are becommgstronger in most of the transitional economies.

2. The on-going reforms in subnational finance in these economies are much more important than seemsgenerally to be recognied. In some countries in transition, the subnational govemments (broadly defined) arequantitatively significant, accounting fur a large, and often gromwing, share of public sector activity. In aU thetransitional economies, the developing structure of intergovenmental relations is intimately related to such criticalpolicy issues as privaizaon, the social safety net, and stabiliatioL Within the fiscal sphero, tax reform, deficitcontrol, and intergovenmental fnce constitute a tripod: unless each leg is set up properly, the entire structuremay collapse.

3. Our assertion is that the design of a weU fumctioning intergovernmental fiscal system is key to almost allof the transition economies' major reform goals. Intergovernmental finances wil have a major impact on theefficiency with which the transition economies perform; on their macroeconomic stability; on the social safety netand on the success of their privatzation policies.

4. Fiscal balance at the subnadonal level is key to macroeconomic stabiliqy. Given the paramountcy ofstabilization goals in almost all of the countries, the central governments have used all the tools in their meagerarsenal to bring stability to the macroeconomyY One such tool has been to shift the deficit down, ensuring anadequate revenue flow to the center - oither by shifting expenditure responsibilities down or by retaining additionalrevenues, even where budgets at the subnatonal level are severely iupaiued Hungary and Russia come to mind,but there are others.

5. The results of this policy, ironically, could contribute to further instability: the budget constraint in thesecountries is still so soft that subnaional governments may respond by accumulating arrears, borrowing (strong-arming their enterpises to finance public expenditures - sice enterprises have easier access to bank credit thando the governments themselves) or developing extrabudgetary sources of revenue. Pushing the deficit down maynot reduce it, but may merely repress it. Worse, some of these 'coping mechanisms ' also reduce the transparencyof budgetary operations, and make the pursuit of appropriate national budgetary policies even more difficult thanit is now.

-JJanos Komai, T'he Socialist System; (Princeton University Press, 1992), p.577.

Zlbe terms subnational and 'local' are used more or less interchangeably, unless speaking of a three tier, orfederal system, in which case subnational refers to all levels below the federal, and local refers to the lowest level.

6. A well-fimctiong - responsibiity for which has bee trafered 'downstairs' in anumber of countries -cannot be effetively caried out by an undefund subuational sector. Where the safaty notis cridcal for the success of Iho transition to a market economy, nd it therfore a national policy objctive, -asin Russa, and ,tguably, in Polund and other countrie - the burden of finaing the safety not should not be onlocal governments, even though, being closer to tho people, subnationl gove ormnts migt administer it.

7. From an atlocative prpctdve, the system of intove n fiscal rebltions will also dtermine in amajor way the officiency with which thb eoanomies perform, and their fu omic o. Loclgovernment ownesip of enteprs - and local ir in their revenus - will inevitably encourge domesticprotectionism (e.g. 'domestic purch rqimes and inter-jurisdictional trade bariers to protect localmonopolies) harmful to economic grwth

8. Finaly, becaus some countries -notably Ruia- ar, so to speak, 'nation-building,' with significantcentrifual fores emanating from the ubnatonal level, inteovermentl finane is also crueil to future natioalcohesion. In Russia it may be crucial even to the contied existence of the Federadon. Even where nationalcohesion is not at risk, demands for greatr 'participatory democracy' have heightened demands from thesubnational level. The strong desire for local politieal control and unfettered local autonomy is a natural outcomeof the end of central plmning. Combined with an inadequate fiscal base, however, loal aspirations and fiscalcapabilities are increasingly at odd., which is giving rise to growing tensions in a number of countries.

9. Even gvimhi2n is complicated by the current environment. Following the transfer in many countriesof a significant number of anterpie to 1matonal ownership, responsibility for privatization now also rests withsubnational govenments. Their interess hero ar unclear at bese they still rely on ethir I enteprises for profitsand tax revenues, ad if privzd, subational govenments will hav to assume the substantial 'non-production'expenditues - for nurei_e, housing, schoob, etc.- tht will e spun off by the enterpris as they privatize. Asystem of inegonmeta finacs tht doe not accommoda thes shifts in expenditure responsibilities andprovide coreponding revenues, will impedo the proco of privatization.

10. In sum, intergovermentl fiscal rlations - far from being merely a 'local matter' - are key to simostof a8l of the transition economies' reform goals.

Traditional vs Systomic Frumewors

11. The traditional anaysis of intergovenmenta finance examines the fiscal functions of local and centralgovermments in terms of their respective roles and responsibilides for stabilization, income distribution, expenditureprovision, the appropriate assignment of tax functions, and the design of a transfer system that providesappropriate incentives. The 'benefit model' of service provision suggest that local governments - whose role inthis analysis is essentially that of service provider - should be financed to the extent possible by charging for theservices they provide, with local taxes making up the remaining gap, supplemented as appropriate by trsasfers and,in limited degree, borrwing.

12. This perspective is of course important in the trasitional economies also. But it misses several key featuresof the roles, responsibilities and economic functions of subnational govemments in the former socialist economies.First, the emphasis in traditional analysis on the local goverment as a service provider ignores its important rolesas produr and as wngr, as wel as the complicated relationships between enterprises and local government in mosttransitional eccnomios. The importunt role of local governments as owners means thst they have a major role toplay, either as potential impediments to, or supporters of, Drivatization. Moreover, the asset stock recuntlytrnsferred to them in the decentralition process represents a potential source of revenue (or, in some instances,of losses). The interaction of subuational finance and privatizadon thus merits careful attention in the transitionaleconomies.

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13. Second, th traditional approach ignors th shrining role of govenment. in most t itional conomies,govenment, both local avd cetral, played a major producdon role and wa the major invoeor in the economy, andtae expendite side of the budget is clutered with expditur - not only sbidies, but direct investmnt,inventory finance and wages - which in a market conomy, are not the responsibility of govemment.Unfortunately, in all des countries govemment reve is cclining mora npidly tha governmnts mo abl, todives themsevas of thes expenditu responsibiities, thus ontributinq to u1bahinit problems. One reponin may countrie ha boen to try to shift the deficit downwans by mang local govemnts responsible for mormexpenditure, while smtanously reducing centrl tansfers to the onatonal sctor.

14. The obvious need for flexibility in today's apidly changing envirment bas led many central govenmtsto attempt to preservo som dogrees of freedom by continuing with the 'negotiated' tax sharng systoms of the pat.But this approch is less and lea acceptable in countries where domands for fair" treatmnt and ec2alization arestrong and where local govemments are seeking gater autonomy. It is also incompatible with the efficientprovision of local public services. It is theeforo especially importat to replace the presnt 'bargained' outcomeswith an intergovrnmetal fiscal framework -of transfers, of local revenues, and of local expenditure responisibilities- that is both firm enough to serve as a basis for action and flexible enough to be compatible with the on-goingstructual changes and reform.

15. The present sftrgy of devolving exuenditures downward while holding back on tansfers is unlily toprove successfl for more than a year or two at best. Indeed, net expenditure eduction at the subnatonal levelmay prove very difficult to achieve. The subnational sector is significant in expendituro terms in many trasitioneconomies -in Rusia, and the CSFR, it accounts for over 40% of total outlays. Elsewhr they account for 10-30% of total outlays. At pesent, for example, state enterprises provide a wide range of social sector outlays: withprivatiznton, many of these outlays will have to be taken over by local governments. Moreover, in most countries,the local government sector plays a critical role in tenn of providing a 'social sae net' which makes the painof the wrenching economic transition more politicaliy tolerable. Since the trvenue sourcs assigned to localgovernments simply cannot finance the level of expected local activity in th i_mmedito fture, the result of shiftingexpenditures downward is likely to be strong demands for increasd, rather than reduced, transfers. In sum, as andwhen expenditure assignments become cleaer, and decentraliation develops further, the likelihood is that thesubnational share in other transition economies wiUl also grow. This means that tho intergovernmental system wilhave to be sensitive to these developments: Notable across the transition economs is the fact that there has beena general absence of concrete empirical estli -leg of 'correspondencew between tax and expenditure assignments andneed for transfers. Legislation on intergovenmental finance relations has typicaUy been developed with noquantitative assssment of its implications.

16. Despite all the talk about *autonomy' and fiscal 'independenceo, few of the countries surveyed offer theirsubnational govemments much in the way of fiscal discretion on the expenditure side. Indeed, most recent legislationhas focussed on codifying the revenue side of the equation -before deciding what expenditure responsibilities ofsubnational governments should be, putting the cart before the horse, so to speak. Expenditure 'autonomy' isenshrined in legislation, but not really effective: there are still centrl 'norms' which govern allowable expendituresin virtually every sector, and centml spending mandates remain in place.

17. The new subnaional governments wiUl also need substantial help and guidance in developing adequate lqolrevnuo systems. The local *autonomy' that has been enshrined in recent legislation has often meant separatingthe spheres of responsibility to the greatest extent possible, so that each level of government reigns in its ownsphere: in revenue terms, this translates into a pm-disposition towards *tax assignment models, and a goal ofreduced *transfor dependance' on the center. The fact that in the pre-reform system, most subnational governmentsreceived revenues from 'their' enterpises has led to a strong bias towards derivation-based sharing models inwhich revenues go to the jurisdiction in which they are collected.

18. It is critical that subnational revenue needs and possibilities be realistically factored into national plans fortax reformL Failure to look at intergovemmental dimensions of national tax policy changes can lead to problems.

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In Russia and Hungary, a share of major natonal taxes has boen assigned to the subnational Ilvel, and recentnational tax policy changes have wrought havoc with the aggrpto subnational revenue base, with vecy eaiceffects across subnational jursdictions. Secod, any thought of aasidg. ut', when the tax itself is undergoingcontinuous definition, is problemical. In m-y transition economie, however, local governments have come outstrongly in favor of revenue assigmet under which they got 'all' the 'renues from vtheir taxes. This seemingrevenue indepndence leaves them with sgnifict residual vulnbility to tax policy changs, however, a fact thatseems genrally not to have ben recowzed. If this vunbity wore to take ito accout, as it dsould be,national fiscal policy reforms would of course be constaned. Rcent tax reforms at the national level,administrative weans and other factors havo meant significat rvenue vowlatiliy, with significant over andundershooting of budgetay tagets. This situaon obviously has implications for the desirability of 'tax assigment'models per s, and the design of sharing/transfor systms.

19. In most countries, for example, the pndcipal locaI" tax is some form of property tax: but in many cases,national governments have hamstrung the revenue potential of this tax by grting exemptions to newly privatizedland, housing, and enterprises. In other instances, local governments are supposd to recive a share of certainnational taxes, often on a derivation basis (e.g. origin, or residence): but such povisions raise both techcal andallocative problems, in addition to biasing national tax policy decisions in often undesirable ways. Even when thelocal tax base is feasible and adequate in principle, in practice it will gerally take some years before the systemcan be expected to produce sufficient revenues to meet perceived locw,; needs.

20. Despite al the talk about *autonomy- and fiscal independence, none of the countries surveyed offer theirsubnational govemvents any fiscal discretion, even over the muior taxes they ane wssigped: rates and bases continueto be set by the center, in the context of the unitary tax sysem. lho paucity of locally-controlled tax resourees inmost transitional countries, when combiaed with the universl reluctnce of politicians to tax constituents too directlyand openly, makes it inevitable that hard-pressed local governments wiU turn to other avenues for revenue: they willwmand increased transfers, they will try to borrow, and they will try to exploit tG the full the new assets they naveacquired as part of the decentralization-privadzation process.

21. The level, design and effects of interaovemmental fiscal transfer. thus constitute key elements in theemerging intergovemmental and local finance system. of the tnsitonal economies. There is a general absenceof 'formula'- based trasfers. These remain negotiated in aggregate and by individual localities. Critical decisionsmust be made with respect to the overal size of such transfers (the 'distributable pool') as wel as with respect tothe distribution formulas to be employed, taldng into account both the severe fiscal pressures on the centralgovernment and the vital tasks to be performed by the local govemnts in the emerging new strcture of the publicsector. Practical measures of *tax capacity, *expenditure need' and perhaps fiscal effort' need to be developedfor use in such formulas. Institutions must be developed at both the central and local levels to ensure that transfers(or subsidized credits) are put to the best possible use: such institutions may include, for example, at the center,agencies concerned with monitoring the perfonrance of local govemments and with providing them with neededtechnical assistance and support and, at the subnational level, various intermediary bodies, particularly with respectto the many very small municipalities that have been created in most countries.

22. As noted above, careful attention has to be paid to the design and implementation of the intergovemmentalfiscal transfer. that seem likely to remain prominent feaure of the fiscal landscape in most countries for years tocome. Caution is even more necessary with respect to borrmin by subnational goverments. A number ofcountries in transition have granted virtually unlimited bonowing powers to local governments without taldngadequately into account the macroeconomic necessity of monitoring and controlling such bonrwing. As yet,however, the relatively undeveloped state of financial institutions in most countries makes abuse of the borrowingpower more a potential than a real problem.

23. The same is not true of the potential misuse of 'locallv owned" state assets, unfortunately, since in everycountry such misuse is already visible. Such local assets may represent a windfall - at least in those cases wherethey are not accompanied by centml policies (e.g. rent or price control) that turn them into a liability. But they may

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also often be misused, whether they are privadzed or not. A local heating plant that is privatized, for example, butremains a (local) wratural monopoly obviously raises regulatory problems: who deals with these problems, andhow? What should be done with the proceeds of asst sales? Under what (very limited) circumstances should suchproceeds be used to finance current local expeitur ? If an asset is not privatzed, but is used to geneote on-going revenues for the local govemment (and perhp some forign partnr, with the municipality using itsownership of land or assets as its contribution to equity), the temptation to sustain and sttengthen any monopolyposition is obviously again a problem, as is that of regulation. Even more damaging is the high pwbability thatmore speculative ventuu - examples include tourist lodge and bakeries - are likely to fail. Equally damaging maybe the dissipation of scare local managerial skills on trying to squeewz money out of such entrepreneurial gambitsrather than focusing on tho more essenal task of trying to provide local public services efficiently.

24. A special problem arises with reap' t to the prices cbrged by those local public enterprises to be retainedin tho public sector. In the past, central governments in the socialist countries used low and fixed prices (includingrents and other urban user fees) and wage controls, as part of their distributional tool kit. The now governmentsin these countries ar now being asked, in a reformenvironmet, to get the prices ight and to use tax policies andtargeted gubsidies instead. There are two important dimensions in the transition economies: First, changes in publicsector prices L.rugc ) clearly need to be coordinated with wage reform on the one hand and with more generalprice reforms on the other hand, in order to avoid undue impact on income and major distributional shifts (as wellas on profits and hence government revenue). Second, central government price mandates -prices were typicallycentrally administered - need to be devolved to the subnational level.

25. Finally, in somn countries, (Russia, China, and others) price reform and other structural shifts wiU continueto bave effects on the tax base and its distribution across regions. Coal and energy price changes, for example implypotentially large shifts in the vadous tax bases, both vtilbin a tier of government in the tax bases of differet regionswithin a country (e.g. a gain in value added in a primary-product producing area after price libealization and acorresponding loss in the consuming jurisdiction) and botwoe levels of government depending on how taxes havebeen assignec or shared. Such shifts must be taken into account when designing the intergovemmental fiscalsystem: they may well constrain the reform of intergovernmental relations, eliminating options that might be feasiblein other countries. At the very least, greater flexibility is needed than in countries where economic structures aremore fixed. Intergovernmental fiscal reform clearly must be viewed as an ongoing Rrocss in countries in trnsition.

Oreanization of the Paper

26. This paper addresses these issues of intergovenmental finance in transitional economies. It argues thata broader framework than is customary is needed to analyze decentralization and intergovernmental fiscal issues insuch economies. This framework must incorporato such elements as the likelihood of continuing structural changesin the economy and continuing political shifts, t4e need to undertake intergovernmental reforms while copingsimultaneously with stabilization pressures and the increased importance of the social safety net, the likelihood ofcontinued (local) public ownership on a significant scale, the financial implications of such ownership and itspossible conflicts with the overall privation objective, and continued vestiges of price and wage controls andother rigidities. A comprehensive and atcurate analysis of decentralization must take these elements into account.

27. The analysis in this paper is based on detailed recent studies of local and intergovernmental finance inHungary, Poland, Russia, Romania, and China, and on less detailed information for the Czech and Slovak FederalRepublic (CSFR - especially the Czech Repub!ic), Bulgaria, and Vietnam. Salient characteristics of the local andintergovernmental system in each of these countriesa' are presented in the main text for illustrative purposes.

21See also the following working papers: Bird and Wallich, 'Financing Local Government in Hungary, No. 869,March 1992; Bahl and Wallich, 'Intergovenmental Finance in China," No. 863, February 1992; and Wallich,Christine, 'Fiscal Decentralization: lnteraovernmental Finance in Rus&iia' Additional source materials are citedin the bibliography at the end of the paper.

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Although the principal focus of Ae disussion is on the cental ad at Europon countria (especially Hungary,Poland, and Romnuia), similar tndencis and problems are visible in all th- countries mtioned and may well aWsobe manifest in the other repubics of the former Soviet Union and fonne Yugoslavia, as well as in similar countrieselsewhore. Komai (in Tho Socialist System) list 26 'soclist' countes in 1987. If we add to this lt the 15republics of the formr Soviet Union nd the S of fonner Yugodavia (and deduct the now-vanihd East Grmany).therm would appear to be at least 43 countries which only fiv yar ago had more or les 'Socialist' syms. By1992, howevor, is probably fair to say all but two of theme counto (Cub nd North Korea) ar now in momo'trnsitional stage, mo tot mom or all of the daslymi of this paper ould be applicable. This paper thaeforerepresents eeially an intetim report on what is suro to pmve an on-going and important problem in all thetrnsitonal ecoomies.

28. The paper is organized as follows: Sectin II reviews r number of geea ius with respect to the roformof governmental structure that have arisen in the transitional economic. This ection elabomates many of the pointsmade above about the importance of thd changig context within which questions of local governmnt roles,responsibilities, and finances are being deided. Section 77 then ouldines briefly what appeau to be the apprpriaterole of subnational government , xuch countries, with special attention to its expediture responsibilities. TheremaiLder of the paper then discusses the issues relating to each of the posible methods of financing subnationalgovernment in transitiotal economies: user chages (Section IV), subational taxes (Section V), intrgovermentaltransfers (Section VI), subnational borrowing (Secdon VII), and the use of subuational govemment asset (Section

29. The matix below summarizes some of the salient feaour found acros the tramition socialist eonaomies.

| ern~kagmeotal Fiwa Reltion in Trmtansn Ecnm2os

r Salient Cbarteristics

Political/Overall Structura Reform Context

* Intergovemnmental finances reforms are taking place in a context of golitical decentralization.

* Govemnment reorganization is also taking place throughout the trnsition and socialist economies,and striving for 'local autonomy', many countries appear to be eliminating the 'middle tier' ofgovernment in their constitutional reforms.

* Intergovermnental finances reforms are taking place in context of overalU sbinking role of

* Intergovernmental finances refonns are taking place in context of a changing role of government.

* Intergovernmental finances reforms are being undertaken simultaneously with overU national Inreforms.

Stabilization

* Intergovernmental finances reforms are taling place in context of macroeconomic instability andinflation, a weak fiscal NOsitiOn of federal/centrd govenment, and a shrinking revenue base atnational level.

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Box ... (contnud)

|* AMakimi ond overall mco concerns domiate the agenda so dt intergovernmentali finacialreform needs to take place in tdis strne contoxt, but cae needs to be takn to prevent the

stabiliduaion objoctive from fully domnting the redign of th inegovermumtsl fian regim.

| Stabilizuon concr lead th center to deal with budgey stin by pushing the deficit down',and hoping the subiational level can do the cutting.

E In some cas, the center has shifted (potentialy large and open-endadresponsibiliti-s for 'social welfare down to local level in an attempt to balamco its budget.

* Expenditure autonomy' is enshuined in legislation, but not really effective: there are still centranorms and mandate in placo, and transfer dependance also impedes autonomy.

* Subsidies reprent a major item in the subnational budgets due in part to central prioe setting onpublic sector prices.

* Use ot 'norms' to define how a service should be provided ;imits expenditure autonomy.

* Cental 'm4a' on wages, and other expenditures limits expenditure autonomy and continue tobe importanL

Tax Assi e and Iafm

* Attempts to make the subnational sector 'independent' are desired by the subnational level md thecenter. center wants each tub to sit or. its own bottom", to assig taxes and be done with it, and toreduce 'transfor dependance'; This is generally not possible, because the tax instruments are notsufficient, and user charges not yet at a level to contribute significantly to cost recovery.

* Subnational goverments want to shake off contral control, and be masters in their own house, andsee appeal in the apparent autonomy that 'transfer independence" provides.

* Tax assignments typically under-fimd local sector: low-yielding revenue sources are assigned orthose which will bear fruit only in the very long term (property tax).

| * There is a genea absence of concrete empirical estimat of 'correspondence' of tax andexpenditure assignments and need for trasfers and legislation on intergoveimmental financesrelations is typically developed with no quantitative assessment of its implications.: * Generd absence of 'formula"- based transfers; they remain negotiated in aggregate volume and byf individual localities.

General absence of transparency in allocation of investment grants/capital financing.

-8-

Box .... (continued)

Privatization and OwnaR

| * Major continued role of subnational govenments in ownership ventures at a timo whencentr/national priorities sQupoxt privatztin This relates to the inadequat revenue bau given tolocalities and their continued financial dependence on nterprises and tranfers for rovenue sources.

| * Potetlly significant negaive consequec for the budget of pnvatizaon (in some cowutres) asenterpnso social expenditures go 'on budget,' and newly pnvatzed enterprises become hader totax. Subnational governments may not want to lot go of this rliable fine=.ing source.

* How to use the saitlry revenues from pnvatzation (debt repaymet, nvestment finance, currentexpenditures). How to take advantage of the asset stock held by local governments.

| orurinD

* In most tansition and socialist economies, there is generous legal access of subnationalgovernments to unlimited borrowing, someimes even foreign borrowing.

Extrabudetav I?unds|

* Extabudgetay funds continue to play a major role, complicating budgetary tansparncy andmacro-stabilization.

Institud2 Famework

* In may transition economies, the instit>tional arrngements needed for diaogue onintergovenmental issues is missing, even though the need for such dialogue is, as noted above,greatr than in makdet economies.

Tax Administration

* 'Inverted. administative systems in many countres where the local administion offices mayhave greater loyalties to local government than to central administratve systems.

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H. DECENTRALIZATION IN PROCESS: TRENDS AND THEMES

A T;me of Trmnsforation

30. Perhaps th most iniportant thing to remmber about the procems of political and fiscal decentralization nowengaging the countries under review is how very r it is. Apat from China, which took the first tentative stepsin this direction in 1979, the subationl sytems now emeging in the transitional economies ar of very recentorigin, as indcated by the dates of some of the relevant basic laws:

Poland - L Self-Governmet Act, 1990Hungy - Local Self-Goveamet Act, 1990RomWnia - Local Govenment Act, 1991Bulgar - Lcal Self-Govemmnt and Local Administraion Act, 1991Rusan Fderation - Law on the Budgetary Rights of Local Self-Govamnet, 1991.

In most cases, additional important legislation came even later - e.g. to set out subnationl revenue sources (suchas Poland's 1991 Act on Taxes and lA Fees) - and in many countries is stiU to com (e.g. with rspect to theprecise ownership and control of some importa local assets). Key elements of the legal framework needed forefficient local goverent are stiU missing in most countries.

31. Moreover, once the basi ucue of local govemment was established, local elections still had to be held,new local governments established, and a myriad of importan administraive details determined. In Romania, forexample, the first local elections woer not held until February 1992 and the new mayoa did not take office untilApril 1M. In the Russian Federation, the first local elections wore held in November 1990, and in Hungary inApril 1991. Even after a year or two's experience, as in Hungary, Bulgaria and the Czech Republic, some mayorsand other local officids, partiularly in the smaller communities, still bave littlo idea of what their real powers,re sibilities, and limitations art. Nor are matr much beuter at the central government level where, in mostcountries, no one really seems to be in charge of dcenrliatiadon, with the result that some key issus appear tohave beon decided (or left undecided) more by accident than design, parcularly issues concerning the interctonof the new local governments with such other lements of the transitional reforms as privatition, tax reform,financial reform, preo reform, subsidy reform, and budgetary reform. Tbis neglect is now causing trouble in annumber of countries not just for the local governient sector but also, to varying degrees, for the success of all theseambitious reform plans.

The End of Central Plannina: Filling The Abhorred Vacuum

32. Unless more systematic attention is paid to these problems in the near future, muas are Ilkely to get worserather than better. Up to now, many of the potential difficulties have been kept in check largely by the continuance,de facto if not always de jure, of the refonn m under which subnational govenments received most oftheir funds from central govemment budgetary transfen which wore basically allocated on the basis of negotiationand bargaining. In this process, the centnl government always has the upper hand, controlling as it does not onlythe total amount of such transfers, but also who gets them, and when. When combined with the continued centralcontrol in most countries of such critical determinants of local outlays as wage structures, enterprise prices, and so

-4In Bulgaria for example, laws passed eady in the reform process only spocified that local governments areresponsible for 'local matters. This vagueness in the law allowed local authorities to claim all or no responsibilityon convenience. This deficiency is now being corrected, and Bulgara is now in the process of preparing a seriesof new Acts covering territorial division, local self-government and administraton, and finance to replace the 1991Act.

- 10-

on, and the ingrained habit of local depndence on centmal guidance, the persistence of this system bas played animportant role in preventing local expenditures from exacerbating the genlly tenuous fiscal situation of the centralgovernment.

33. But this situation is unstable and will not long persit in the absence of strong central political control.YAlready, many countries are finding that the combination of th manifesdy strong desire for local political controland the unbalaced mdate - virully unfettered 'local autonomy', but a totally inadeque fiscal base - logallybestowed on the new local govenments is causing trouble. In the Czech Republic, for example, central autoditiesare properly concened about the national implications of both local povemment busines activities and localborrowing as weUl as the fragmentation of the national education system. In Hungary, whore local gover_nN canspend their budgets, most of which come from national transfers, any way they want, simiar problems areemerging. And in Russia, which is with the CSFR the only fonmlly "federa transitional country, separtisttendencies fueled in part by fiscal pressures and imbalances are raising funamntal political problems.

34. The CSFR, of course, has already decided to split into two sparate republics, effective in 1993. Evenmore dramatic, although of course largely motivated by forces stronger than those discssed here, is the cse offormer Yugoslavia. These two are by no means the only countrie in central or eastern Europe to be etmicallyheterogeneous. It may weU be tat in the end the only way such countries will be able to hold together in ademocratic fashion will be by reconstituting themsdves as vey "loon" fedrations - like Switzerland or Canada,in which the subnational units (cantons or provinces, respectively) are also 'sovereign states in some importantrespects. In these circumstances, central-ational negotiations become as much or more exercises in diplomacyas in the design and implementation of efficient and equitable govermental structuresAY In contrast, the discussionin the present paper assumes, as does the legal framework in every country considered here except Russia (and thesoon-to-vanish CSFR), that the transition countries are organized essentily as unitary states, and that the essential

role of local governments is to ensure the efficient provision of local public sevices and to act, where it is efficientto do so, as agents of the centrl government.

35. At present, in most of the countnes under review, those local officials who are not simply waiting moreor less passively, either for orders to come down from above as they have for decades or, more hopefuUy, for theirfuture to be unveiled for them, have understandably been using their eaergies primarly to attempt to wheedle moremoney out of the central government. In Romania, for example, where the entire 1992 trnsfer budget was spentby the middle of the year - largely on centrally-mandated subsidies to enterprises - it is not suprising that Bucharestcity officials were to be found two or three times a week at the Ministry of Finance trying to secure more fumds.Other local officials, forhtnate enough to possess clear tide to significant assets, have been selling them off andusing the proceeds for current expenditures (as in some towns in the Czech Republic) or trying to use their assetsas equity in joint ventures with foreign investors (as in other towns in both Hungary and Romania).

36. On the whole, however, there is as yet little eidence at the local level of wide deviations from desirednational standards in the provision of essential services, other than that resulting from the general fiscal penuryafflicting all these countries. Similarly, perhaps partly reflecting the relatively undeveloped financial sector, thereis also no evidence of either significant budgetary deficits at the local level or of excessive (or often, any) localborrowing. As it gets harder to squeeze muoney out of the center, however, and as it gets more difficult to get easyfinance from seUing off assets, subnational governments in the transition economies are going to find it increasinglytempting to move in both these ditions.

-China, where such control largely remains in place, is of course an exception to this genemalization, although eventhere many of the problems discussed in this paper are manifest.

-I'For analysis relevant to such federai states, see Shah, *Perspectives on the Design of Intergovernmental FiscalRelatiers," Worling Paper No. 726, 1991, and Bird, Federal Finance in Comprative Petpective (Toronto, 1986).

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37. With respect to education, for example, the finacial incentives in the preent Hungarian systom may inthe future, unless changes are made, lead to larger towns with seondary schools being unwilling to accept stdentsfrom smaller towns without such schools. whe completely unconditionalnature of intergovenmemtal fiscal tansfersin Hungary make it very difficult to penaliz such actions. Simily, national education standards have vanishedin the Czech Republic but have not as yet been replaced by either guidelines or nrles: totalitarian education wasundoubtedly an vil, but it is not obvious that anachy is better. For the fist time in decades theim is clearly apossibility that wide variations in the quality of education will eerge depending on the ficl resources availableto the municipality in which a studkt lives. Similarly wide vartions may equally anse in health, in so-al welfareexpenditure, and in other aue of local govenint activity as the power of the center to command vaniss. Thisoutcome is unlikely to be caosiderd desirable by most citizens.

38. It is one thing for local expaoditure choices to reflect the wishe of local officials who have beendemocratically elected and who wa spending funds secured from the citim who elected them. But it is quiteanother when sovices with substantial juisdictional spillovers are underprovided in poor areas owing solely to lackof fiscal resources, or when trasfer monies provided by taxpayers as a whole for specific national piposes aremisspent by local officials responsive only to their own local electors. Yet both of these outcomes are all tooprobable over time, given the virtusally unrestricted 'local autonomy' conferred by some of the new localgovernment laws (e.g. in Hungay). For much the same easo, the almost unrestrained borrowing authoritybestowed on new and untried local authorities by some of these laws carries with it the potential of eventud fiscaldisaster.

39. As yet, the subnational system is too now in most countries for most of the bad things that might happento have occurred. But ther aro enough signs to be worrying, and it is critical to use this time of transformationand reform to continue to develop the local govemmont stuct in a more positive direction in a number ofimportant respects. It is, for example, important to carify exactly what is, and is not, meant by local autonomyand to flesh out more clearly the role envisged for local govenunents. It is also important to develop adequateinstitutions at the centrl level to support the many new, and often small, local govenunents that have been created.Moreover, the role and nature of institutions inrmediate betwee the central government and the local govemmentshas also tuned out to be both a critical issuo in many countries, and an impoant differentiating factor from countryto country. Thes questions are discussed furdtr in the balance of this section.

Political Decentralization

40. The reform of local and intergovernmental finance is taing place in the context of political decentralizationand in particular a strong commitment to decentrliation of certain responsibilities and revenue to self-governinglocal administrations1z. In reaction to decades of over-talized public administration (and related party control),most Eastern and Central European countries are gngaging in a process of extensive decentralization, graduallyreducing the role of government in genera and the powers of central govemment institutions, and especially theirplanning and control apparatus, in particular.

41. In line with this tendency, autonomy and control over 'local matters, and accountability for them, is beingincreasingly devolved to the newly-elected local governments. The centrl government wants 'each tub to sit on itsown bottom', to assign taxes and be done with it, and to reduce transfer dependance'. Local governments wantto shake off central control and be masters in their own house, and see appeal in the apparent autonomy that'transfer independnce' provides. For those and other reasons, the principle of localautonomy is now enshrined

-'In Bulgaria however, the pace of the former exceeds (and precedes) the latter. There is a risk at present ofincreasing fragmentation in the number of self-governing units in Bulgaria because of the perception of localgovernments that 'self-governing status will lead to greater budgetary transfen from the center. In order tocounteract this trend, it is important that aspirations for local autonomy be tempered by specifying a threshold forself-financing/own source icvenue mobilization.

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in the legislation of most transitional countries. As a rle, this legislation affims d liation, local financialautonomy and the administraive 'independence' of the uunadonal level from cental control. The languagediffers, but the geonel intent is clearly to free subnational govenments from the 4ead hand' of centralized control

and to let local democracy flounish.

42. These political reforms are paralleled by dcentaliton of fiscal responsibilities. Some form of subnationalgovemment stucture had existed in most of the transition economies mder the socialtst regime. However, the fiscalsystem of this regime was essenidaly 'unitary,' with the sub-national level being little more than an edminunit or 'departmet' of the center, with no indepe;dnt fiscal or legisltive responsibility. Kornai (I992, op cit)sets out the former socialisS system in considerable detail. It is revealing that this lengthy study hardly refers to theexistence of subnational state administrations, noting only that they are tightly cntrolled in al respects by thecentral bureaucrcy. In effect, local govenents were basically udeconcentrated' nits (or branch offices) of thecentral govermment and had little or no financial autonomy. This was true even of those countries such as theUSSR, and Czechoslovalia which were formally called 'federations'. It was also true in the Russian Federation,despite the fact that Russia's 31 autonomous republics and national regions wero said to be 'autonomous' and tohave independent budgetary rights. Policy-making was hence very controlled and centrHzed and local governmenthad virtually no independent tax or expenditure powes - part of a larger picture in which the budget itself was seenonly as the handmaiden of the Plan.

43. Reorganizing Governuent. Now, however, virtually every transitional country is to varying degreesdecentralizing, deconcentrating, and delegadng functions and responsibilities.Y Decentalization has many merits,both in political and economic terms. It has, for example, the potential of improving the efficiency of localgovernment by subjecting its actions to the scrutiny of the local electorate. Autonomy over local decision-makingand expenditures also frees local governments from the heavy hand of centrd control. As yet, however, thesebenefits have not been attained for two quite distinct reasons: the persistence of the old ways and certain flaws inthe new dispensation.

44. In Romsani, for example, there are at least three important reasons why local autonomy has little meaningin reality as yet. First, although the Public Finance Law clearly says that every local government is supposed tohave budgetary autonomy, it also gives power to the central govment to change local budgetary allocations.9'Moreover, as noted above, the habit of deference to centrl commands, even if no longer legally binding (orenforceable) still persists in many areas. Secondly, at the present tibm local govermnments in Romania actuallydeliver very few services themselves. Instead, their basic role is to contract with reaies autonomies (local publicenterprises) for the delivery of most local public services. These 2ngj, like al enterprises in pre-reform Romania,were of course just another part of the public sector under the previous regime. Under a 1990 Law on theRestucturing of State-owned Economic Units, these enterprises are now financially independent. Although theyare legally responsible to a board comprised of me4bers of the relevant local government, they appear to be actingboth more independently and at the same time more in response to the many cental controls and egulations to

WDeconcentration refers to dispersion of responsibilities within the central government structure from the center toregional *branch offices', and differs from 'delegation' in which local government may execute certain functionson behalf of the central government (and be accountable to it for their performance), and 'decentralization', inwhich full decision making and implementation authority is transferred to local govenmment, which is accountableonly to its own constituents.

2'Art. 51 of the Public Finance Law states that 'the distribution of the revenues and expenditures or categories oflocal budgets ... is established by the decision bodies of each county [district] and of the city Bucharest.' But Art.22 of the same law states explicitly that the central government has decisive power in the formation of localbudgets. Each year, local budgets are submitted to the Ministry of fmance no later than July 1. The Ministry ofFinance examines the draft budgets and has ten days in which to "ask for the necessary modifications' in order toestablish budget balance. Most importantly, 'in case of divergence the (central] Govemment is to decide'.

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which they are stil subject thn at the behest of local govemments. Finally, as in most of the transitionaleconomies, Romania has created a large number of small, poor local goverments with almost no resourc0s of thoirown. Autonomy' does not mean the same tbing to a small, poor rural commune as it does to a large, rich city.

45. Lcal institutions are more developed in countnes such as Hungry, but these three problems - conflictinglegal interoptations, tangled rmlations with enterprises, and considerable diversity in the capability of localgovemments - exist almost everywhere, and cast some doubt on the real significance of local autonomy.'Moreover, even where such implementation problems do not exist, the fiudamental problem with th way localautonomy is being approache in the transition oconomies is that such autonomy is not moeningfil if it is notaccompanied by capacity, and it is not desirable unless it is accompanied by responsibility.

46. To make local autonomy menjrtef, local govements need adequato locally-controiled revenues. Notonly must decisions about the provision of government services with local benefits be made by local governments,but such goverments must have the resources to carry out such decisions. As developed further below, localexpenditure discretion is stil limited in imponant ways: some such limitations may be good; others clearly are not.Moreover, the fimdamntal inadequacy in most couttries of the local revenue base (see later discussion), and theresulting continued dependance of local finance on ad hoc transfers means that revenue capacity is also inadequate.Greater expenditure discretion in those expenditures fiuly assigned to the subnational level and greater flexibilityfor sub-national govemrments to raise their own revenues seem needed in most countries. Such revenue flexibilityand autonomy is a crucial step to maling local govemment more accountable to local residents, and to improvingthe efficiency with which local public services are delivered.

47. One meaning of local autonomy is thus that local governts should be able to raise and spend revenuesfrom their own revenue sources in any way they wish - subject to cenain limitaions on the revenue bases to whichthey have access (see below). Since local governments are responsible to local taxpayers for what they do with thefunds they raise, in principle it is neither necessary nor desirable for the central government to tell localgovemments what they can do with their own money. If those who pay for local services financed from localrevenues, the local taxpayers (and voters), are unhappy with what their locally-elected authorities do with theirmoney, they may dismiss them.

48. On the other hand, if the centml govemment is unhappy with uwht some local government does with themoney raised from local taxpayers, its unhappiess may be unfortunate from some perspectives, but it isunavoidable. What local autonomy means is precisely that there is nothing that the central government can or shoulddo to alleviate any such distress it may feel - barring extreme cases such as corruption or when other national lawsare breached.

49. Local autonomy emphatically does not mean, however, that local authorities should be able to do whateverthey want with other people's money - that is, with taxes paid by other than local residents. Truu local democracy -presumably the ultimate reason why 'local autonomy' is considered desirable - means *responsible' democracy,

which in turn requires full and explicit political accountabilitv to the source of local government resources for whatis done with those resources. Local autonomy in this sense is thus not only consistent with, but also requires, thattwo important conditions be satisfied:

1. The access of local authorities to taxes that may be *exported- to non-residents should beseverely restricted.

2. Subnational governments should as a rule be accountable to central government (that is, totaxpayers in general) for the use made of central government transfers.

Acceptance of these conditions, as is necessary if efficient resource use is to be achieved, has strong implicationsboth for the design of the local tax system and for the design of transfer systems, as developed below.

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50. Th'e eenal economic role of subntional governient is to provide to local residents those public servicesfor which they arm willing to pay. As already noted, local govemnmets must be accountable to their citizens forthe actions they undertske to the extent those citizens finance those actions. Similarly, local governments mst beaccountable to the central govemment to the extent they are in effect acting as 'agents' and are financed bytransfers. Accountabilitv in this sense is the public sector equivalent of the 'bottom line' in the private sector.

51. Such accountability clearly requir thst subeational governments should, whenover possible, choa forthe services they provide, and, where charging is impracticable, they should finance such services from taxes bomneby local residents, except to the extent that the contral government is, for reasons discussed later, willing to pay forthem. Public soctor activities are unlikely to be provided officiently unless the lines of responsbiity andaccountability are cleady established along these lines.

52. On the one hand, then, local govemnments need to be given access to adequate resources to do the job withwhich they are entrsted. On the other, they must be held responsible to those who provide these resoure - localresidents or central goverments, as the case may be - for what they do with them.

53. In principle, local govemments should therefore not only have access to those revenue souces that theyare best equipped to exploit - such as residential proprty taxes and user charges for local services - but theyshould also be both encouraged and permitted to exploit these sources as fuUy as possible, subject to certainlimitations. Unless local governments are given some degree of freedom with respect to local revenues, includingthe freedom to make mistakes for which they are accountable to their constituents, the development of responsibleand responsive local govemment in the trnsition economies is likely to remain an unaainable mirage. On the otherhan;, if local governmcats are given cate blauche to spend o-ter people's money, the alocationa, distuibutional,and maccc consequences will almost certainly be undesirable.

54. There are of course dangers in permitting local governments even limited freedom. One danger in the eyesof some is thst they will not utilize fully all the revenue sources open to them, thus allowing the level and qualityof public services in some areas to deteriorate below the standard considered desirable. But this is not a realproblem. If the savice in question is reaUy one of national importance (e.g. reseach) or one in which there is astrong national interest in maintaining standards (e.g. poverty alleviation), it should be nationally funded at leastin part and its achievement monitored correspondingly. If it is not a matter of national interest, why should thenational government be concemed? If the local electors do not like what their local govenment does, or does notdo, they can 'throw the rscals out' at the next election. As noted above, the freedom to make mistakes, and tobear the consequences of one's mistakes, is an important component of local autonomy.

55. Another danger, more salient from an economic perspective, is that local governments may attempt toextract revenues from sources for which they are not accountable, thus obviating the basic efficiency argument fortheir existence. To counter this inevitable tndency, central govenments should in principle deny or limit accessto taxes that fall mainly on nonresidents such as most naual resoure revenues, pr-retail stage sales taxes and,to some extent, nonresidential real property taxes.

56. Another way to counter this problem to some extent may be to establish a uniform set of tax bases for localgovernments (perhaps different for different categories such as big cities, small towns, and rual areas - althoughthis may not be politically acceptable in all countries), with a limited amount of rate flexibility being permitted inorder to provide room for local effort while restraining unproductive competition and unwarranted exploitation.It is especially important to provide adequate flexibility to exploit good local tax bases to avoid creating a situationin which the only flexibility available veal governments in their struggle to cope with budgetary prssu is byexploiting such economically undesiable sources of revenue as local business taxes or, even worse, local businessenterprises. As emphasized later, the business of government is not business, and enterprising municipalities shouldnot be encouraged to develop local enterprises in order to secure the revenue they need to function.

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Tho Size and Scope of Government: How Many Levels?

57. In the pmroform period, virtully all the countries under review had a multi-tier organizion, with thecentral level implemeaing its control over the local level throuh an of government. The centralgoverment wa responsible for the overall plan and budget, and the intenrmdiate level, variously called 'Oblast(in the Russian Fedation); *Judet (Romania); County Council (Hunguy), and *Voivodu in Poland, was theadministrative, control d surveillance agency tough which o cer effected conol and implementedpolicy.w This middle tier ovemw tho expenditur of local governts and wa the chnol for centil ficalflows to the localities. Substatvoly, however, noe of the countries discsed her was organized, from a fiscalperspective, u a federaton. Although the Russian Federotin gv nomial autnomy to its 31 'auftomous (ornational) regions, okmup and republics, these sb-ntioad gove too wero nither fiscally idependent norable to determin their own expenditur and tax policies. At the other extrme in some ropects is China, a unitarycountry with a vey decentralized inison.

58. At present, only Russia and Czechodova have a thre tier fml systm of govemment, comprisingthe federal govemment, republics, and regions - and t Czech and Sloak Fedeal Republic, as it is formallycalled, is scheduled to septo shortly into its two componet pua. All the other countries discussed here havea uitarv system of government. A first look at the lol stucture suggests that Poland, Hungary, and Romaniahave a two-tier level of government (central and local), Rumds, China and Bulgaia a three-tier struture (central,provinces/county/regional and local), and Vietnam a four-tier level of goverment (czatml, provincial,municipal/district and comneighborhood) a shown in Table 1. In fact, however, matters ae not so simpleanywhere. Romania, for instance, has two tier of local govemmt (the old judets and municipalities): all of thearea of a judet is divided into unicipalities, but in principle each type of local government is independent of theother. In Hungary, on the other hand, whilo the old counties still exist, they really have no functions, so that thereare m effect only two lovels of government, cental and locaL On the oter nd, in Budapest (as in tho citie ofthe Czech Republic) there are *subcity (distict, or ward) councils and goverments with elected councils and theirown budgets and assets, so that thoe local level of govenmnt itsf ha two tiers - as indeed it does in the largelyunrefonned stucture of Vietnam. In Bulgai, the municipalities ar the basic unit of self-government, but theyhave contiguous bordes and therefore both urban and ural. The municipality itslf has an elected Council andMayor, but urban settlents within the municipaity also hav an elected Mayor (no Council) with delegatedexecutive power, from the municipality (ie. county). This lower level is therefore a deconcentratd level of localgovemment.

59. As a rule the middle tier of goveiunt cotinue to aist in vestigial form in most tansitionalcountries, but it is struggling both for a role and for legidmacy. Most coundries seem to want to shed thisintermediat tier, associated with the former control economy, as if to put their past behind them. In some countriesthe role of the interdiat tier is now limited largely to overseeing the constitudonality and legality of localgovemment oprations. lI others, its role has become one of coornanting cental government policy at theregic *al level. In most, however, there are few quesdons more in flux than the present and futre role, if any, of'intermediate lvels of government.

60. In HAomgm, for example, ther are now 8 regions, 19 counties, and 3070 localities. The regions, headedby a central official called the Commissioner of the Republic, have two functions: (1) information anddissemination, which involves collecting data on local govenmet activities and providing information to localgovenments to facilitat the implementation of national policies; and (2) to ensure that local government actions(e.g. on taxes) are constitutional. The functions of the 19 counties, formerly the main teritorial control instrumentof the state, have also been severly restricted. counties retain some minor fee revenues and are supposed to be

L' These are, strictly spealdng, decentralized branches of the central govenmment administration, not an indpendenttier. There are 88 oblasts in Russia; 9 oblasts in Bulgaria; 19 County Councils in Hungary; 49 Voivodships inPolp.nd; and 41 Judets in Romania.

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responsible for functons of an intuAunsdicional natur that servo swvral localies. In contrast, the localgovemnments (almost twice the number of the former 1563 local councils) have considerable expenditureresponsibilities, the right to spend national transfes and shared ta a they so fit, and amost unlimited powerto borrow, own and dispose of property, and to manag, establish, or sel public eaterpises.

Table 1Trends in cr t Governmnt Orgnization

country UnitayFdal # of Tiern Em N of Tiers (preet)___________ _______________ (pro-rform ) Structm

Hungary Unitary 3: central/county/ Unitary 2: cental/locallocal

Poland Unitar 2: cenral/local Unitary 2: voivodship8/

Ronania Unitary 3: central/regional// Unitary 2: central/locallocal _ _ _

Bulgaria Unitary 3: central/regional/ Unitary 3: central/oblasslocal (regions) obahina

(municipalities)CSFR Federl 3: central/state/ 2 countries 2: republics/local

local

Russia Federal 4: central/oblast/ Fderad 3: federal/oblast/myons/vi-t ge rayons

_ _ _ _ _ _ _ _ _ _ _ _ Soviet_ _ _ _ _ _ _ _ _ _ _ _ _

China Unitary 3: centrl/province/ Unitary 3: central/local province/

local

Vietnam Unitary 3: centDal/province/ Unitary 4: central/local province/

municipal/commune.

61. T,he stuation in Romania is quite different. Although the 41 judets continue to exist, there are now twocompletely different administrative structures in each judet The first, headed by an appointed prefect, is essentallythe deconcentated territorial admnistaton of the state. The seoond, haded by the elected president of the judetcouncil, is the locl govenment at the judet level of local gov ere, which is responsible for works of regionalinterest but which has no hieruchial authority over the 2,948 other local governmentsU.

L'Me situation where a local govemment jurisdiction coincides territorially with a deconcentrated echelon of thecentral government administaon can be found in other countries. T.he Romanians have basically borrowed theFrench local administtion system as it emaerged from the 1982 decentralization reform, at least as far as the rolesof the departmt (judrte) and the communes (comune si orase) are concerned. (They did not copy the truly newfeature which that reform brought about, nmely the creation of the region as an additional intermediate layer of

- 17 -

62. In EgJg, the 49 vovoidahips ane esetaly deoncetred public service inmdiaes for cti centralexpenditures (mostly in hlth and socal welfa), although other central expenditures are camed out locally byline ministries. All local government functions ar caried out directly by the 2383 gjina governmons. Prestplans, however, ate for a new iermediat tier of local govenmet (probably about 300 units called powiats)to be put in place in 1993. Similarly, in the CzechRepublic, whoe there are at preseat over 5000 localgovebmts, there ar also 7 regions and 75 districts e_nally left over ftom the preious regime, and plans arebeing considered for creating anything from 3 to 20 to 7S "second-fierm local govamenats.

63. Finally, in tIe Russn EfSop, a sligbtly different paten is emerging, with the obast level tddng ona laorg role and emerging as an iwpota unit in its own right. ndeed, if the fiSecal reforms at the subnationallevel proposed in macmst logislation are implemted, the Russin Federtion will have decentlid expenditureresponsibilities and to a lesser degre, rvenues, to the oblst level and will take on the character of a tme federalstate.

Size of Goveme Units: Efficiey-and Other CMgM.

64. Although the initial reaction against the previous intemediate govemments as udesrable reminders ofthe old regime is dendable, so is the obvious concern in many countries to put something more acceptable intheir place. As shown in Table 2, most of the east European countries have created a large number of small, andprobably not viable, local government units. In Hungary, for example, the averago population of local goverments(excluding Budapest) is only less than 3,000. In Romani*, half the population lives in local governnowt units witha population of less than 4.000, such units accout for 90% of all local governments, and the average populationof all local govenments is only 7,500. Poand's locad govenms ar smilarly fragmented, with an averagepopulation of only about 16,000. The Czech Republic, a compact country with a little more than 10 million people,has over 5000 local govermments. In Bulgaria there are 3,984 elected local govemet units (settlemnts) withthe average population of 1500. At the more aggregate level, there are 273 municipalities with the averge size ofaround 30,000.

65. Such extensive iixm on may be good for getting govemment close to the people, but it alsosubstantiaUy complicates intergovernm tal relations - it is, for example, imWposible for the central govemment tomaintain direct bilateal relations with so many units -, reduces the political ~roice of local government as a whole,and in many cases yields localities that are sunply too small to provide efficiently all the public services demandedfrom them. At the very least, even if it is decided not to reate a formal intermediate tier of government, somemechanism for coordination and consultation is likely to prove necessary. Possible models abound in the world,e.g. the 'municipal federations that exist in many of the Nordic countries, under which localities orgaize on avoluntary basis to provide cerin local services, or the Nordic secondary commun-e, county-like bodies with theirown elected officials responsible for providing services of an inteijurisdictional nature.

local (regional) government). Similar situations exist in other countries, for instance, in Germany (Bavaria) wherethe landkroise are both local govemments (gebietskorperwhaften) and the lowest echelon of the State administration.

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Table 2Deloizationu Scale and Sie of Govenmenw

Country of units of local governumet Average Size

Hungary 3070 municipalities 2,834

Poland 2383 gnas 16,000

Ronuia 2940 urban and rural mniucipa4itie 7,S0041 judeta S37,804

Bulgaia 273 municipalties 30,000

CSFR 2843 cides in the Slovak Republic 1,867*5500 cities in the Czech Republic

Russia 2000 rayons 125,00088 oblast 2,840,909

China 30 provincs 33 millon

Vietnam 44 provincs 1.47 mon

Note:* For the CSFR as a whole.

Sum,orting Subnaional Government: The Ihstutional Setting for Subntioinsl Govemmentisl Reform

66. The lack of an approie contral govnnt strucr to moitor and support tho new local govanmtsis a common problem in central and eastern Europe. In Poland, Hungary, and Vietnam for example, thDre existsno institution or designated person in cbare of the deentlion of the localities and the Ministty of Financestill plays a lead role in the budgetary function and other fiscal issues at the local level. In Russia the formationand implementation of fiscal polcy is done by the centrl government and three Parliamntay commisons. Thebudget is submitted to the Parliament for approval, the collection of revenue is done by the State Tax Service, andexpenditure authorization is dr the control of the MOF. In Bulgaria, the Ministry of Regional Development,Housing Polcy and Construction is responsible for formulating the policy on terrtoral division and localadministrative functions and guiding the reform progam whilo the MiniAry of Finance retains primy control overthe linked issues of local govrment finance and budgeting. In Romania the formulation of decentalization policyand implementation of local government reform is tife resnsibility of tho Department of Local Governmet Affairsof the Office of the Prime Minisr and the Deparmt of Tax Administationand Local Budget Management ofthe Ministry of Finance and Economy. Simildy, in the Czech Republic, both the Ministry of Finance and theMinistry of Economic Policy and Development are involved in shaping the intergovernmental finance system.

67. Despite (or perhaps becue of) the involvement of a number of central govenment institutions in a numberof countries, quite a lot that should be done sem to be going undone. Among the tasks for which responsibilitymust be clearly establied are MomitOlinl and ssg subnationd fnms both in total and individually. Thistask might be located in the Ministry of Finance, in a special local govemment department, or it might even begiven semi-independent status with some local goverment involvement (like the US Advisory Commission onIntergovernmental Relations or the similar body in Australia). There ae pros and cons of each possible locationthat need to be considered carefully. But what is beyond dispute is the need to ensure that the central authontieshave a better underanding of both the existing situation and the likely effects of any proposed changes than is trueat present.

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68. In addition, reular and dogiled fingaial da should be maintained on subutional govenments. Ideally,this requires;

(1) the establishme of uniform financial reporting (and budgetng) systms - perhaps withdifferent degre of complexity for different categories of local governments; and

(2) the desigaion of an agency responible for coUecting and procesng then data in a timelyfahion (which wiU probably, in a larg and complex country, requie use of some samplingthniques as well as occasional census exercises to provide the needed frtame).

The first of these quiem ts in tun requirm the development of such systeum and, much more difficult, theirimplementation, which will geally require subsatial trining and folow-up efforts. Developing such'infrastricture' is neither quick nor cheap, but it is esential if substantial ad important public sector activities areto b decentlized - for whatever rsrn - without losing sight of what is going on in these importat pua of thepublic sector. Implementation of this recomendation may rqui additional centnl govem ntotinstitutions (1) to develop and maintain the reporting systems, (2) to tran and support local govenment officials,(3) to develop independent auditing procedures for local administrations and their rovenueoeaning entexprises, and(4) to run the stical side of the opation - with the latter being a main input into the work of the instituionreferred to in the first recommendation above.

69. Additional training efforts are clearly needed to uagade the technical canacity of subnational overnmentsto carry out efficiently and effectively the expendituro functions for which they are now responsible and others withwhich they may be entusted in the future, whether in exercise of 'local autonomy or as delegated agencies of thecentral goverment In some insance. (e.g. education) the neary support should probably como from therelevant central minisy, while in other instane (e.g. road and waterworks) it may come fom the ministry,regional agencies, universities, private sources, or some mixture of the preceding. In view of the heterogeneousnature of both the services that are (or may be) decenalized and of most countries, it is unlikely the same solutionwill be appropria in aU coass, but it is clealy a high-pority item to work out in detil exactly who is going tosupport the new lood role in each functionl area and how that support is going to be delivered. Each functionalarea - including the budgeting and financi rporting discussed earier - has different needs, problems, andpossibilities, and will likely have to be treated diffetly.

70. Finally, an especially high-priority task for the needed central unit monitoring local finance is to analyand evaluate intermovernmental fiscal transfers. As indicated later in this paper, there are many questions that mustbe raised about the objectives, the design, and the effects of such transfers. There is also much to be said forencouraging much more informed and open discussion of these matters than is common in many countries,especially when the whole process is as novel as it is in the transitional economies. Regular publication of data willof course help, but one cannot rely solely on an interested party - the central govermment - to carry out, andcertainly not to publish, all the analysis that is really needed in any country in which intergovemmental financialissues are important, whether in political or economic terms, or both. For this reason and others, there is muchto be said for establishing as soon as possible in most countries one or more smal non-govermnental researchinstitutes focusing on local government problems.

The Changin Role of Government: From Ownership to Service - Provision

71. Decentralization and intergovernmental fiscal reforms are taking place in the context of a major change inthe role of goverment in the trasitional economies. Ia the past, governments at both the national and subnationallevels have been involved in almost every aspect of economic activity. The state owned all enterprises, from thesteel plant on the 'commanding heights' of the economy to the local laundry. The state organized production,allocated labor, planned exports, and so on. The first stage of decentralization in some countries began in the1970's, when the ownership of some smaller industrial units and the retail sector were transferred to subnational

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govemments. By the late 1980's, local goverments in countries such as China owned a substantial patt of theeconomy - light industry, and some manufactuning.

72. More rect reforms aim to decentralie owneip to tho privat sector. The trnusition is still far fromcompleto. Although all the east European countries are committed to privatzing stlte assets, to liberaliang prices,and to withdrwing from the role of the state as direct pducer and prvider of ecoomic goods, many produetiveassets - indudrial assets, agriculturl and urban lad, the housing stock, commrcial property - remain ingovenmment hands, somedmes local, sometimes national.

73. While everything is in flux in most countries, as a nle at the local level the satus quo contasb starklywith the role local govemments generally play in maurkt ec4onmies. In the lIser, local govenmments provide basicurban inftucur and local public services (sometime through local public enterprs) and often act as localadministrators of nationa policies in such area a education, health, and social sevices. In the former socialistpattern, on the other hand, enterprises owned by local govenments had their investments financed from localbudget', and local budgets in tum derived revenues from Otheir eantepriss. C

were close, and the distinction between enterpris functions and government functions often murky. Lcaities oftenasked enterprises to construct and finance such facilities as roads and schools, clinics and even sports stadia andclubs; 'donations' to the budget for one-off outlays were also com rm Jt made little difference whether suchoutlays were directly undertaken by the enterprise or via the more circuitous route of profit transfer, and fundingvia the government budget: the burden on the enterprise and the not budgetary position was the same. All this hasnow changed, or is in the process of change.

74. Until recently, for example, most local government revenue from enterprises came from 'profi:remittances'. As a result of reforms to the national tax system, and especialy of the enterprise tax system,however, these remittances have largely been replaced by taxes on *thei enterpriseeW. Somo countries stillprovide explicitly for such 'ownership' rights to enterprise taxes: in Romana, for example, local governments(iudets and municipalities) have the right to both profits and dividends taxes levied (by the central government) ontheir public enterprises. In Poland, prior to the racet tax reform, both profits and dividend taxes similaly wentto the 'founding' sbnatidonal government, and in addition these govemnments (vovoidshipsand gmina) got specifiedshares of the similar taxes levied on state enterprises which had significant activities in their territories. Thisprocess was so complicated that the Polish tax administration spent almost as much time allocating enteTprise taxesamong jurisdictions as it did collecting them.

75. Even where more modern systems of tax adminitraton have been adopted, as in Hungary, there is stilla strong tendency for local governments to feel they have a primary claim on the tax revenues generated within theirjurisdiction. This 'source entitlement approach to the allocation of fiscal revenues is of course familiar in suchcontexts as international taxation and the taxation of natural resources. But it is seldom so visible at the local levelas it is in some of the transition economies, in part because of the obvious gross inequities that would result fromallowing local governments to keep large shares of the revenues levied on firms producing for a national or worldmarket. Of courmse, exactly the same problem arises, or wil arise, in the transition economies, as noted below.

76. Ownershig versus Service Provision. The fundamental change in the role of subnational governmentsrepresents a major challenge which has as yet not been fully realized in most countries in trasition. The key roleof local governments is no longer as o but as saervi viders and reguators. The wrenching reforms mostcountries are undertakdng in order to achieve macroeconomic stabilization and to compress the state budget mayeasily produce perverse effects at the local level. As noted below, some central govermments, for example, haveshifted additional expenditure responsibilities downwards in the hopes of improving their budgetary position.Revenue assignments and/or transfers to local governments are generally tightly budgeted for the same reason. The

Uy See Tanzi, Fiscal Reforms in Socialist Economies in Transition, IMF, 1991, for a full discussion of the nationaltax reforms that are in process in most countries.

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result is inevitably that local govenments ar sorely tempted to rely on entises for continued budgetary oudlays,and consequantly to protect locally-owned enterprises to ensure their profitability. Unless a workable framworkfor intergovernmentsl finance is put in place, budgetary stringency is thus likely to create additional hurdles todisassociating local govenments from thir enterps.

77. T'he IQ-S4t Oda facing both local and centra govements are also very difrent from the past.'Adm trativo inteventiods', such as the detailed regulation of prices, the administation of waiting lists forhousing, and the allocadon of land and mtria supplies are no longer qriropriate. Instead, what is now neededis to develop and implement an entirely now regulatory strctur to provide tho conditions within which the marketcan do its job e.g. reulation to avoid monopoly, prevent food adulteration, curtail financa fraud, and so on. Inthis vein, one essential task of the national goverment will be to set up an adequate and clear legal framework notonly for the private sector but also for the deces.alized local public sector. Local govermmnts face their ownunfamiliar regulatory task, particularly with respect to land use, enviromental problems, and retail trade.

78. Not only is the role of govemment changing, but its mo is changing. Intergovernmental fiscal reforms aretaking place in the context of an overall shriniing role of government, with all thstresss that a smaller pieimposes on decision-makers. As shown in Table 3, the size of govenmment was much larger in the transitioneconomies than in mulaet economies. In many cases, reforms have alrdy had a major influence on the overall"size' of the govanment sector, although much more some than in other. In China, for example, the governmentbudget declined from 40% of GDP in 1979 to Ims than 20S of GDP in 1989; in Hungary, the similar decline wasfrom almost 70% of GNP to about 60%. examples. In Ru via, the geneal budget was over 60% of GDP in thelate '80s; the target for 1992 is only 35%.

79. Although the figures are not always clear, on the whole it appears plausible that the shrinling of thenational level has been generally pamrlled by a shrinkdng of the subnational level of government: in Hungary, forinstance, subnational expenditure fell from 14.3% of GDP in 1988 to only 10.4% in 1991. Predicting future trendsis difficult becus of the changing nature of the intergovernmental system in most of these countries.

80. On one hand, as already mentioned, central govenuments continue to shift important expenditure items'downstairs' in an attompt to balance the central budget. It is not clear if the final result of this process will bereduced total expenditures, increased central trasfers, or increased local taxes - although some combination of thefirst and second possibilities seems most likely in most countres. On the other hand, as a rule public enterpnsescontinue to provide a number of basic local public services: they support the construction and maintenance ofhousing, keep kindergates and pre-schools, and so on. Larger entrpses may even have their own hospitals,retail outlets, and other non-production facilities. As privatization reforms impinge increasingly on the enterprisesector, pressurs to replace some of these activities by local budgetary outlays will undoubtedly be strong.

81. Thus, at the same time that localities may be reducing expenditres by shedding unnecessary andunproductive subsidies (for example, to housing) as part of the economic tranition to a market economy, they mayhave to take on some expenditures previously caied out by enterprise. Whether such enterprise functions willaccrue to national or subnational budgets is hard to predict: it is equally difficult to predict the net change, in theshort term, in the size of the local government sector. In Russia, as one example, the non-productionresponsibilities of enterpnses are, virtually across the board, likely to be taken on by the subnational sector, thussubstantially increasing its expenditure responsibilities. Indeed, such a transfer is de facto already taking placeowing to the financial difficulties of many enterprises. Unfortunately, no one has either quantified the dimensionsof this problem or envisaged any workable solution for it. In principle, however, the shift in expenditureresponsibilities from enterprises to local govemment should be matched, at least to some extent, by a correspondingchange in the revenue base of the local govemment. Otherwise, the budgetary consequences of privatization arelikely to be very negative. But as a mle, that revenue base is already inadequate for the tasks demanded of it, asdiscussed below.

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Table 3Reform and the Size of the Goveommt Sector

(Expenditue as % of GDP)

Country Exp Sub-nationl Sub-nio Total Exp. as Sub-national Sub-nationalas % of Exp. as % Exp.u% % GDP Exp. a% Exp.u % ofGDP of GDP of total of GDP Totia Exp.

PrE-1989 Post-1989Hungary 62.7' 14.3' 25.4' 57.4 10.4 18.1Poland 49.7 14.7 35.3 40.1 4.00' I0Romania 45.1T 3.64 11 24.67 6 10.8'Bulgaina 55.2 N.A. N.A. 43.0 25.0 23.0CSFR 58.46 20.5 34.5 60.1 20.2' 34.3'Russia* 1.0' 20.7 13U 16.0 1L/ 41.0'r 17.0 43.0China* 271r- 14.3 53.0 22.8 N.A. N.A.Vietnam 11.3 3.4 31.0 12.3'2 3.9 33.0

Notes: (Seo end of paper).

82. In the past, goverments m the socalis countties employed fixed prncs (including rents, and other urbanuser fees) and wage controls, as essential elements in thOeir dstbuti tool kit. Now, however, as part of thereforms currently under way, the tansitional economics a required ind to 'get the pices right and to use taxpolicies and targeted subsidies instead. As a rule, replacing conmr price subsidies by targeted sbidies (witha much smaler budgetary impact) will require the development of new infmaion and twcng systems.W Someobservers think that the targeting problem will be relatively eay in the transion economies because of the existenceof a large 'control' data bas in such countries. This hope is probably naive, howevr, given (1) the flaws in thatdata base (e.g. in Poland several million people exist *off the books a far as officialdom is concemed; in Hungaryand especially Romania, thern e important low-income ethnic groups Ohat ar smilarly lusive); (2) the dependenceof official information on a local control system that is diintgatng apidly, if it has not already disappeaed; and(3) the increasing gmwth of the euphemistically-labelled 'infornmal sector.'

83. Indeed, since the breakown of cenal planning, ctrl governmet in most countries have surprisnglylittle information even about the activities of local goverments. Only in a few countries (e.g. Hungary, Poland)do local governments now appear to provide detailed financing reports to the conter. Reporting of data onextrabudgetary funds and borrowing is also deficiejti

84. Public sector pricing is likely to be one of the last areas to be reformed in most countries. While nationalprice reforms have liberalized most private sector prices,1 at the subnatioual level governments are having a muchharder time adjusting prces for public sevioces, even for prvate goods provided by the public sector, such ashousing rents (and such ancillary services as water and heating) and transport fares. Adjusting these prices is of

I' For useful discussions of some of these problems, see the following papers presented at the recent World BankConference on 'Public Expenditures and the Poor: Incidence and Targeting': Milanovic, 'Distributional Incidenceof Cash and In-Kind Transfers in Eastern Europe and Russia;' and Jarvis and Micklewright, 'The Targeting ofFamily Allowance in Hungary.'

-LPhere has been much discussion about the 'big bang' vs gradual approach to price reform, but even in countriesas committed to gradualism as China there has been major price liberalization.

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course essential both for efficiency ard to enhce local rvenues. Doing so, however, implies major changes inthe cost of living and in welfiae, so tat changing such public sctor prie will entail major, and undoubtdly veryunpo ar, distributional shifts if not pro)pey coordinated with other refoms. Such shifts, if too wrenching, or tooquick, could upet the filo democcies tat havo only just emergod in most countries.

85. At the -m tm that fiscal i-a is going on, national tax ytems are also undegoing majorchanges. Major naionl tax reforms havo been initiate in almwt every country in a effort both to make their taxsytm more compiblo wit thos of a market ecnomy and to pwvide a soeu source of revenues to finaceessential ste budgetary outlays il the face of prvation. While there are considerable variations of dotil fromcountry to country, as a rule tax reform involves: (i) the replaeint of profit remittances to govemment as ownerwith corprt income tuation (CIT) to the govement a tax colloctor, (ii) the introduction of a value-ddd tax(VAT) to replac the classical socialist *tuover tax", which is bet described as consisting of thousands ofcommodity-specific rates, or wedges betwoe adminisratively-st rtail and wholesale prices; (iii) the introductionof personal mcome taxes (PMl) -wage controls woe the 'mplicit tax' in tho pre-form era there wore also payrolltaxes, which are geneally retained; (iv) the itroduction of propety and land tati01on i rdimentary form; and(v) the elimination of a number of ts aimed basicaly at regulating nterprise behavior (such as the excess wagetax, wage bonus tax, excem profits tax).2I

86. As theso national level taxes ar being revamped, the system of local fimucing is smultnewously beingchanged, both intentionally and to some extent uintendonally. In Hungay, for example, the VAT and PIT wereintroduced in 1990, the year the Local Self-Government Act was passed. In Russia, tho CIT was introduced in 199,1,and the VAT in 1992, the sam- year that the redsign of the intergovrnl fiscal system was to be implemented.In Romania, prepartions are underway for the ino t of the VAT in 1993, and of a global personal incometax in 1994, with initial local govemment reforms having taken place already in 1991. In the Czech Republic, theVAT is also scheduled to come into offect in 1993, dieo -m year in which a now system of intergovenmentalfinance is supposed to be put in place. In Bulgara, the curret VAT implnion date is July 1, 1993MI. Inall of these cases, there appears to have been almost no consideation in the basic national tax reform of the fiscalneeds of the local governments, even though it is clear that, given the fundamental inadequacy of the revenuesspecifically assigned to local governments in most countries (see below), thes govemments are likely to bedependent on some form of 'tax shaing' in some form for yeas to come.

87. As these press become manfest, further reforms are assigning to, or sharing with, local governmentstaxes whose design is new, whose operation is untestd, and whose administration is inevitably weak, as discussedlater. Moreover, even though the national level reforms are ofte intended to be 'revenue neutral', there is littlebasis for revenue estimation, and hence little certity as to expected yields. The potential volatility of taxes sharedor assigned to the subnational sector is compounded by these countries' overall economic cycicalityll. Thedifficulty of ensuring corresponden=c between the expenditure responsibilities of the local goverments under thenew systems, and their assigned revenue base or share, is self-evident.

I'For fuller discussion, see Tanzi, Fiscal Policies in Economies in Transitin

1 In Bulgaria a comprehensive tax reform under preparation compnses draft profits tax law, VAT, taxadministration, territorial division, and excises.

J2See D. Go, 'Revenue Uncertainty in the Transition,' CECPE, RPO# 27118, forthcoming, 1992.

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Stabtization: Mem Macoeconomic Context for D ion

88. The economic reform progms in the trasitioal economies have had to addre both andlibsaip- n concerus. Integovenmntal fiscal roforms are tWring place in the context of a w *k overallnacroeconomic position and often a weak cntral govemnmnt fiscal postion. The move to prvate epr phas contributed to a more vital economy, but has accenuad tho problem of a shriking rovenue base at the nationallevel, as many of the smaller new private enterprises elude the grasp of tde tax net and ptesnt major challengesto compliance and tax adminisa . The filing state-owned entpise sctor no longer prvitdes th revenue baseof earlier days. The tax refoms dencribed above are undoubtdly deirable for maket effici ency, but untexperience with the new system is gained, reven shortfalls seem all too likely. The expediture side of the budgetcontinues to be burdened by heavy outlays for both consumer and producer suidies, as well as often generous cashbenefit program and now and sometimes large outlays to support failing enteprises and to restucture orrecapitalize banks.

89. In Hungry, the consolidated deficit of the general gove_nxt reaed 4.3 % of GDP, with inflation of32 %, in 1990, tho year tho new system of local self-government was introduced. In the Rusasia Federation the fiscaldeficit is variously measured as either 15% or 30% of GDP in 19912W, and a likely deficit of over 10% of GDPis expected for 1992; inflation is soaring. In Romaia, the mesurd budget deficit has been rather small, but aninflation zate of 161% in 1991 reflects an unstable macro-economy, and suggest that the fiscal accounts understatethe deficit: the central bank carres out heavy qasi-fiscal opeaons, and the banking system finances expendituresthat are fiscal in nature. Only in China, with its gradual economic reform (and continued tight political control),is there rough budgetary balance and comparatively moderate increass in the prce level (See Table 4).

90. For these reasons, stab and overal o acro-eco ic concoms often domiate the national agenda.Reducing fiscal iwn%aances - both those at the center, and those potentially emaging at the subnational level, isinvariably a fimdamal rquiemt of the adjustrnt progrm to which most transtional counties haveagreed. The curlm t stuation provides a shp contst with public fic in the pro-rform penod, when theuaitary fiscal system imposed close adherence to the Plan in the implementationand execution of the budget, which,together with stict controls over the financs of enterprses helped sure broad balance in public sectorfinances.A' In paticular, under the old rgim, the finaces of subnadonal govemment had few macroeconomicconsequences. Revenue sharing served only as an administrative device to simplify a system of central resourceallocation. Expenditures were guided by planning norms. The result ws tat in an accounting seam at least thebudgets of the suboational governments were always in balance, with any necessary adjustments being made simplyby accounting tmnsfers.

'Ihe difficulty in measring the Russian deficit relates inter aLia to the tretent of the Union expenditureresponsibilities taken over by the Russian Federation beginning in November, 1991, following the dissolution of theUSSR. The higher number cited rofers to a 'notional' deficit, which assumes that Russia had financed Unionexpenditures for the full year.

2"As discussed in the present section, ther are clearly potential macroeconomic problems that may arise fromsuhnational finance. Nonetheless, it is important to note that subnational governments cannot on their own causesuch problems since they cannot 'print money (unless the central govenmet lets them do so e.g. through locally-controlled banks): in the end, it is invariably the validation of subnational deficits by central governments that isthe proximate cause of national deficits and the ills that so often ensue. In this, as in -any other ways, nationalgovenments ultimately get the local governme they deserve.

V Of course, one should not exaggerate the robustness of the budget in pre-rform times, since there were clearlymany fiscally unsustainable elements from a long-term poerpective in most countries.

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Table 4M nmi Indicators

Country Deficit as a Subnational laflation Current Account M3 growth% of Deficit as a (1991r Balance as % (1991-2)GDP (1990) 9 of GDP of GDP (1990)

Hunguy -4.3 -.4 32.0 +1.0 l. 29.3

Poland -2.4 N.A. 249.0 +4.8 45.0

Romania +0.9 +.3 161.1 -12.4 100.8

Bulgaia -13.0 _/ -.8 334.0 -2.7 N.A.

CSFR -2.0 I/ +.0 54.0 +2.7 26.7

Russia -20.6 N.A. 382.0 -7.2 I/ 75.6 I/

China -1.8 N.A. 5.3 +3.7 26.7

Vietnam -4.1 N.A. 36.4 2/ -2.0 19.6

Source: Recent Economic Indicators, IMF.1. For 1991; 2. Average inflation for 1990. The end of period inflation for 1990 = 67.2%; 3. For 1M.4. For Bulgaria a more meaningful measure is the cash deficit (net of foreign interest arreanrs) which was 8.5 %.0 Most receat year after price libmlization.

91. Shiftina Ex&enditure Responsibilities sDownstairs". Current stabilization concoens have led the centralgovernment to view fiscal decentaization as an opportunity to reduce centra expenditures. This is being done intwo ways: First, by spinning off expdiiture rsponsibilities to the subnational level, thereby reducing its owndeficit, and second, as an opportunity to reduce fiscal tnsfs, purpordly to make local governts more"idependent, but with the welcom side offect of reducing centl outlays. In paricular, a number of countriesare trmsfernng icresing responsibility for social expenditures and the social safety net to local govemnt. InHungry, for example, the responsibility for "welfari expeditures was tansferred to the localities. In Russia,the contral government trmnsfered social expenditurs equivalent to some 6 % of GDP M992) to the local level bythis means, with the objective of "pushing the deficit downa, presmably in the hope that the subnaionalgovemnents would perform the politically painfiul utting required - even though the demand for these servicesis likely to grow with the worning conomic situation. More rcnly, responsibility for key national,interurisdictional investments (e.g. in transport)- has al8o been transferred to the subuational sector.

92. Even some of the extensive asset tansfers to local govenmments that have taken place in most countriesappear to have been partly motivated by budgetay concerns. Some of tho 'assets' transferred - notably housingand some entepises - a really liabilities given the heavy burden of maintenance and operation of these units andthe fact that rental income (last adjusted in the Russian Federation in 1928!) does not cover even a small part of thescosts.

93. Reducing Untersovemmental Tansfers. The fiscal difficulties at the national level have also led someFinance Ministries to focus on reducing intergovernmental transfers as one way out. Transfers have been seen asthe ,compressible dimnion" of the federal budget. The principle of "budgetay independence" mentioned abovehas been interpreted to mean that subnational governmets should be financialy self-sufficient, which in turn impliesthat direct transfers should be reduced and even eliminated. In reality, however, in most of the transition economiescentral transfer to local goverment sector are very large, reflecting both the rudimentary tax base available to localgovemnments and the center's reluctance - again to avoid fiscal vulnerability - to part with any of the major tax

-26-

bases and to assign them to the sublationdl level. As a nle, however, the amount and distribution of those trasfrsis determined each year on a discretionary basis in accordance with central fiscal exigencies.

94. While such budgeta flexibility is clearly desiable from the cental govenment's short nn view, it isa mistake to view t fers as a completey *comprusble' poion of the national budget, as appears to be the casein countries such as Hungary and Romania. Many of the soevices provided by ubational goverments, particularlyin view of the 'pas-down' phenomennn already discused, contitute estia expeditues for political stabilityor for futre ecomic deveopmt There is no way that th mny small local govements that have been cratedin most countries con finace the provision of thoeo servce at an adequate level out of their own rsouc. Evenfrom a short-nm dtbilizaton prspective, an undefunded subnaltional sctor in the curmt environment is all toolikely to result in a sitution in which the only way local governme can cope with budgetary presre is by usingeconomically undesiable sources of revenue sucha profits derived from the exploitation of incomeming assetstransferred to them and from diret public ownership of local busine . At the same time, local governments'open-ended expediture responibility for 'social asuistmce' is liklUy to sult in emorgency recurrec to the ceralgovnent for additional funds, or simply the unnal accrual of aruas tough short-term borowing.Arrears have been a problem in China in the recent past and are cuntly a major problem in Russia. One wayor another, intergove n transfers are thus likely to be an important component of the central budget for yearsto come in most transitional countries.

95. Deficit Control . Placing limits on the subnadonal deficits is of course an obvious way in which centmlgovernments can ensure that the subnational sector does not give ise to additional or unexpected m nomicpressures. Such limits are in place in Russia and China, for example. In an overall framework of hard budgetconstraints, such provisions may make sense, but this is unlikely to be true when budget constraints are still "soft*in other sectors, notably the aeteprise sector.

96. The combination of controls and soft constants may give rise to perverse outcomes.W In response tothe apparent surplus in overall local budgets, for example, Russia has, as alrady mentioned, sought to squeeze thesubnational sector by tranferring expenditures downwards, re-adjusting tax shares and minimizing traDfers.WSince local governments by law cmnot mn deficits, however, nor for the time being can they borow even for

liquidity reasons, there is almost by definition a 'surplus' at least sufficient to meet the *cash on hand requiementsof monthly local outlays. Reduced revenue shares or transfers can never eliminate this surplus: on the contrary,since the system canot be in deficit, such measures will only lead to measued expenditures far below normal levelsand increasing cumulative arrears.

97. Budgetarn Autonomys. Although local govenmunts in most transitional countries (1ruland, Hungary,Czechoslovakia, Bulgaria and Romania, for example) have thoir own budgets, quite separte from the state budget,this nominal independence by no means implies the absence of central controls. In Romania, local budgets aresubject to the central govemment's implicit approvaW. The central govemment has the final say, especially if

k'For examples of dysfunctional incentives for economic liberalization as a result of fiscal d lion policiesin earlier Chines experience, see e.g. Wong, 'Fiscal Reform and Local utrialization, Modern Clina April1992, and *Central-Local Relations in an Era of Fisal becline,- China Ouarterlv, December 1991.

WThe budget surplus, meured on th report csh basis" for the subnational sector amounted to 1.2% of GDPin the first quarter of 1992. See Walich et al; Intergovernmental Finance in the Russian Federations; forthcoming,1992

W(According to both the Law on Local Adm ion and the Law on Public Finances the authority that approveslocal budgets is the municipal council for municipal budgets, and the district (judet) council for the district budget.Budgets have to be balanced by law. The role of the prefect, as reprevntstive of the State, is to ascertain, ex-post,that local govemments abide by this legal requirment. Ihere is a disguised direct control of local goverment

-27 -

the budget i unbwaed. In conbt, in Russia sc budgetry approval is implicit in the system of negotiated taxsharing and transfers, whose levels ar conditional on an approved level of expenditues. On the other hand, Chinaand Vietnam slill have a unfiedbud, in which central and subnational plans and accounts ae jointly presented.In China the local budget must be approvod by the provincial goverment, and the budget of the provincialgovernment must be approved by the cewr.

98. More generally, even though the local govermts have been given autonomy in pnnciple, in practice theylack it in my areas The lalc of tnsparency or claity of laws further e rbat the problem. e rel degreeof expenditure autonomy of localies is often limited. In China, for example, local gove_nts have little formalor legal independence with rospect to etheor local taxes or the level and compoition of expenditu. In almost allthe countri under eview, ce expenditur noms and enl spending and wage mndats continue to Carryweight in many u. Tndee, in Roumaia thes facton stil weigh so heavily that thero is hrdly any real localexpenditure discreton as yet. In the Czch Republic and Hungry, on the other hand, ther appears to be muchlooser control on the expenditure ide. On the oter and, the lack of veue atnmyis seere w eveywhore. Thecenter usually stipulates caps on local taxes and in some cas even spocifies the tax rates and tax base.

99. Tax Administration as a Sowce of Vuleabil . Fiscal d talion, and the political decentrlizationthat accompanies it in this now environment ha left some cOentl governments c -o caly vulnerble foranother important eson To ensure macroconomic stabiliation, the feded goverment must be able to containits budgetary deficits, which means relying on its own budgetary revenues. In some tansition economies, however,tax adminition is decenulized, that is, aubnaional governments collect revenues on behalf of the center, andtransfer them upwards 'we Table S).PI In Russi, in the CSPR, in China, and Vietnam, all revenues other thancustoms and trad taxi ar collected by local a ons. As the experience of the former USSR (and theformer Yugoslavia) suggstb, delegation of collection responsibility, with its potential for non-compmiance, or worse,reliance on contibutions from member publics, are only vible means of fincing the centrl govermment so longas central political control reman strg (as in China and Vietnam). The potential withholding of tax revenuesfrom the fedeal budget threatens Russia today; even in China non-compliant loCal administrtn, and the revenuecontracing' system this gave rise to, have been the source of m_cnomically cyclical federal revenues. 2-'

expenditure magent because all expenditur involving the use of centrl govenment resources requres the ex-ante approval of the Miistry of Finances' local trsury office, and, since fiscal tnsfers represent up to 90 % oflocal resources, the Govemment, legal arrangements notwithstanding, continues to actually exert a close to totalcontrol.

3 Strictly sealing, the tax dministrations am doconconat arms of the federal or central administration. Defacto, however, tax officials may have strong ties and loyalties to the local governments which often provide theirhousing and fringe benefits: ther is conideablo evidence in some countries (e.g. Russia) that local tax officesrespond to local policy.

Uv See Szapary and Blejer, 'The Evolving Role of Fiscal Policy in Centally Planed Economies under Reform: TheCase of China,- IMF Woring Paper 407, 1989; and Bah and Wallich, "Intergovenmental Finance in China".World Bank WoDkng PaPr Series No.863, 1992.

- 28 -

Table 5Tax Admunistraton in Trulstion Soci;at E3c9;lp

Country "Inverted Centmalzed

Hungary x

Poland xi

Romania x2

Bulgaria x2 l

CSFR x

Russia XI

China x l

Vietnam x

Notes:1. In Poland, all national domesic taxes, and some local taxes and fes are colUected by treauy offices and thentransferred to state and local budgets. Other local taxes and fees are paid directly to Gmias.2. In Romania and Bulgaia, the local goverments do not have their own administrton. All local taxes arecollected by local branches of the MOF.3. The State Tax Service is in the proce of centalifzing.

100. liDcations for The Lonuer Tern Intergovemmenbl Svstom Although intergovernmental fiscal reformis necessuily takig place in this strned macroconomic context and hence inevitably reflects changing short-termfiscal needs and psures, care must be taken to prevent the stabilition objective from fully dominating theredesign of the intergovemmental finances megime. A major challenge facing the trmnsitional economies is todevelop an intergovernmental fiscal system which is an optimal combination of mles ad di - one dbt wiUbe both flexible enough to be compatible with macroeconomc stabdilization and the major structural shifts whichare taking place in the economy, and at the sam time provide a stable framework for the effective operion of bothcentral and sub-national govemments in the lcnger termL

101. One solution along these lines that has been adopted in some market economies, for example, pivots arounda system of intergovernmental transfers in which the totl is flexible with cbanging macreconomic circumstnces -for example, some percengta of total central taxe - while the distribution of this total among diffent subnational

govemments is Oformula-driven", with the amount received by different localities depending on such factors aspotential "fiscal capacity' and assessed need. This approach repreents a compromise, in which the center givesup some degree of control over its revenue but also insulate itself from ad hoc and possibly escalating demandsfrom localities, while localities avoid discretionary cutbacks in local trasfers to meet stabilizaion objectives, withall the expenditure dislocations that this implies. In most of the countries under review, thus regularizing the overallsize and distribution of the tanmsfer, like strengthening local finances by broadening the local tax base to improvelocal tax yields, represent high-priority reforms. This point is developed further below.

- 29 -

m. WHO DOES WHAT? THE ASSIGNMENT OF EXPENDlTURES

The Efficieno Cae for Deeentized Local Gt.

102. Whilo local governmmnts may have some effect on stabilization policy and some role in distributivepolicyLW, their mn-or economic role is clealy with respect to the alocation of resources. From an efficiency pointof view, the basic rulo of expenditure asignment is to assign each function to the lowest level of governmentconsistent with its efficient performance. So long as thm are local variations in tses and costs, there are clearlyefficiency gains from carrying out public sector activities in as decenraized a fashion as possible - and these gainsare larger the lower the price elasticity of domad for these services.

103. In principle, therefore, the only services that should be provided centrally - or, in some instances,regionally - are:

* serviees for which there either are, or are for overching political reasonspresumed to be, no significant differences in demands in different localides (e.g.national defense; public health);

* services with substantid 'spillovers betwoen jurisdictions that cannot be handled in someother way such as by contracting, or by grant design (e.g. interlocal tmnsportation; airand water quality); and

smervices for which the additional costs of local adminisraon are sufficiently high tooutweigh its advantages (e.g. administration of income taxes).

Apart from the last of these three cases, even these soervics can often be delivered most efficiently at the local level,although they may well be financed in whole or part by central transfers. In short, in principle, moat public servicesshould be delivered at the local level, with local decision-makers deciding what services are provided, to whom,and in what quantity and quality. To put this the other way, the only services that should be provided centrally arethose for which there are no differences in demands in different localites, where there are substantil 'spilloversbetween jurisdictions that cannot be handled in some other way, or those for which the additional costs of localadministration are sufficiently higher to outweigh its advantages.

Expenditure Assinment in Practice

104. As noted earlier, under the previous socialist regime, since local governments basically acted as units ofthe centrlized administration, local expenditures were included in the unified budget of the central govemment.There was no question as to who did what. the central govenment did everything, sometimes directly andsometimes through its local administrative units. Under the new local government laws in most of the countriesunder review, however, specific expenditures have been assigned to the local level of government as shown in Table6. In the Czech Republic, Hungary and Poland, for example, local goverments have detailed expenditureresponsibilities in the area of education (primary and kindergarten), transportation (local or urban streets),environment (garbage collection, disposal, industrial waste), housing and related services, and health and welfare.In Russia, on the other hand, there is no legal definition of expenditure assignments at the local level, except for

WSince local governments are governments as well as service agencies, they are inevitably interested in thedistributive as well as the allocative effects of their policies. Income redistribution at the local level may be swverelylimited by the openness of the local economy, but if a goverment is not concenied with distribution, it is not agovernment at all but simply a service agency. Nonetheless, within-jurisdiction distribution is ignored here asunimportant relative to the importance of setting up the basic mles of the local finance game so that each localgovemment is fully accountable for its actions.

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Table 6Expenditure Assignment to Subnational Authortiei_

Hungary Poland Romnia CSFR China Vietnam Bulgara Russia

Defence No local No No No No No No Military bousingresponsibility

Justicetatemal Enforcement of No Public No No Secwity ofsecurity rights of national security is farmingesasand ethnic provided byminorities local

branches ofthe Minidryof Interior

Foreign Econotnic No NoRelations

Education Ptimary and Kindergarten None Partid All schools A Several specialsecondary only and pre- tesponsibility in primary througb expeadisues vocatiolincluding day care elmentafy the Czecb university level. (epil and schools. Wages,and high schools chools only Republic Local current) of operation

governmenta pnimary and contmction andcover all salaries, econdary maintenance of almainten nceof schools. Sone primary andschool fciliies, kindergartens. seondary chools.adminitration and Some technicd Local enterprisesscholarhips and vocational build ome

schools facilities

Culture and parks Supponting Over-lapping Cultural activities No Some museumscultural activities responsibility such as cinemas with oblast

for cultura and broadcasting significance. Allactivities recurrent

expenditures of allsport and parkfacilities And al

othcr culuralfacilities.

,I 01 i i,,i i jsi ti'31ti .1*111i

_ G 0 q8t1 .

_ _ _ _ _ _ _ _ ii _ _ _ _ _ _ _X_ _ _ _ __Q -_1 t

1 _ _ _ _ _ _ _ _ _ _ ii_ _ _ _

^:i L_ 12 10t 1i <~~~~~~~~~Ia IaX,1

_ __ __ _ _ _ __ _ __

l X -

- 32 -

Hungary Poland Romania CSFR China Vietnam Bulgau RuooLibannes Partial No (book No No Lal iaui Speci ibaqy

peogmbliy purchase aevicca at tdethimh the eblM levde anbudgs of the mm l ibayMiniiry of ices at heOdhnC ) isyo lve-ld.

Poke ccs No - -- Sofia has a Road (rafic)

With die

Wiliti; ed_er

Sanitation Garbae collection Ownerhip and Rcflu colection Pat of garbagegarage clection) Provision of colgcticurat bothcold water at oebb and rayou__________________ ~~~~~~all levels levels.

Sewge Garbage coLection Owneri ad Sewage Gar Moat of theand eleme pwviaoaof colhecti clectioG and epetcioaclekanig ewage evceo i wm b ln die e _pendluSt doese_mea rayon level and

some op_Sonezpendiuresat the

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~village levdPublic utiies (ps. Water Supply me Ditict Wdcar spply Subsdi toelectricity, and war) snanaeet and ligh heating and iDn_uctn. hmboJs (ntrmuenance of wtder cep_e) at the-________________ public cemteries _

. yon lev

- 33 -

_________________ Hungary _ Poand Roasua CSFR Chn VKtnam Bum RussHousing Housing Sha Haiwng No Builliqg _ Ma a of Maie e is demgement eqpibilty evices _h ea_ oq of

pasurs sa te evofOdIu2ScI govammsern rPq.tY e _efiFuming. bousing.building sl Cqitasubvdifrin foe expenditures axrre"ade iacdeunls

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ -. athesalse oed.Price and ohw subsidies Rest subsdin Rem Eer Dict subsidies Ysn Mas Danc t For .eels, Muss

uWies to to agrullual I dmug. tnot ndhuehold cooetive, sadyto food sac and pb and sbidies to _me-lge bw bred, alk andtransport eutpst t srvie within afinas a_ tedi,ubsidies e ot bIvolved unicipaities. nyon level. Also

in tde Hatig vabg dy remt sbdiespoducfioof isce 1992.lbcal ubric

Socil Welfae Social care Voivodship Welfare Homles Part obistffciies sch as r obilitis expeu for disebled ad oVeammtold e an ede who s- o ad o yandhandicapped chids, rayon kvelhames ophanagcs, die n nt ofdisbled dec. pwrgan tanded

byupperlevd

New Public enterprie Can esablih new Can ablih Can ablih Cm establish Can etablis aw Can Can esablish Capacity to ivest(productive secto) domestic joint new domesi ne m domestic domneacjoint estblis ne domestic il joist Vema;ntsvente joint ventu dometic jowt vewn vesra nw joist ventos (pSOpewea

joint domestic of privatizationventures joint proced if ryo

Al th ayon leeths aso IincIud10 percentofany

subordination

- 34 -

Hungary Poland Romania CSFR China Viem Bulgaria RussEnvironmant Proection of tae Envimeat Measue to RexOsibl fornvkionent prtction Outlays. iwmrne aNd el

wehabiritate the environmentalenvkoseit pblems, e.g.

pri rvation of_ _ _ _ _ _ ~~~~~~~foca

State-owned Enterpriss Major local Local Loca Major local Major ownerhip Local -*Gmup C-ownerhip ownership ownership ownerhip esponsibities of ownership enterses e.g.responsibilities reponibilities reqnibiliti rsponsibilities lght and heay respotibi local lightes indusries. lities inuy, housgPrvide subsidies condruction anto cderprise for food indury.technia Rayonupgding d ronibilitybuilding of exis only if dhetemaporary eepid iswarbousel transftrd to the

loal klvel

Nftes:i Jo Victnam, local governmentc are responsible for al of th abov activiti f ey s fi uderthrdit diction. at, each klve ofgovem tis reponibl for thaa activiie which fals undtheir juisdiction. / '-' implies no infonnstion. 3 'No' implis no applicable to ubaniol governments.

35 -

social progrms (which account for a major pat of expenditure). In effect, tradition and inrtda have eablishedexpenditur ssignmets i Rusia which i many cases roughly correpond to best practice (benfit) areas.Unformnatly, pehps owing in part to the lack of legal clarity in ths area, it appears tht thes pincipleare beinginreasngly violated in the courn of the on-going chages in the ietgovemntal finance system.

105. Although in some ways it is not typical, Romuiia provides an intereng example of some of the thingsthat are going on in tho a of expenditur assigment in tho tnsitioatl conomies. At first glance, for example,the new local govomment law appeas to asign local govenments exclqsive technical and financial responsibilityfor many more fimetions (e.g. policing) than those that are actually exercised. In fact, however, this asgnmentis only on condition tht national laws or '[centrall govemment decisions' do not specify otherwise. That is, inpractice, local govenments do only what the centraI authorities wat them to do. The main financa responsibilitiesso far actually asumd by local goverm ts in Romania are basically for vaious mor activities in socialassistance, municipal service, cultwre and arts, public investment, and maintenance. A A rogars local transportationand district heating, local govemments simply serve as conduit C3r the channelling ok coetral government subsidiesto the public service enterprises (regie autonome) delivering there two services. Witth the gradual elimnation ofconsumer subsidies (to be completed in 1993) and the tnusfer of legal ownersip of these entetprises to the localgovemments (to be completed in 1992) the situation may change, though it is far from clear how, finacially, thelocal goverments will handle the problems stemming from the now responsibilities.

106. Romana is thus unusual in the extent to which some important expenditures usually considered to havestrong 'local benefit' characteristies are still at the centrl level. In particular, and in contrast to most othertransitional countries, education and health remain the sole reponsibility of the contrhl govemment in Romania,reportedly to ensue a minimum standard in the provision of these important services. Recently, however,increasing financial pressure on the central govenmmnt has led to the proposal for some of these expenditures bedelegated to localities. As is not uncommon in the transition economies - though highly unusual in western countries- both public scurity and fire protection ar also provided throughout Romania by local branches of a centralMinistry.

107. Overlapping responsibilities between the center and localities with respect to culture and social assisance,on the other hand, are common to y countries. For example, local museums are often financed by local budgetsand national museums financed by the central govemment budget; but books for both local and national librariesare purchased by the Ministry of Culture. Similarly, both local and centra governments fund programs related tochildren. Such' *xtdit h -h-ring '-i.., with diffeent levels of govnmt responsible for different subfunctionsof particular expenditure activities, or with more than one level of government playing an important role infinancing, regulating, and providing particular services-is a common characteristic of multi-tiered governmentalstructures: it may sometimes be efficient, but it almost always obscures the key question of precisely who isresponsible, and accountable, for what.

Local Public Enterpriso Ownership

108. Romaia also provides an extreme instance of a problem found to varying degrees in most of thetransitional countries: the importance and complexity of the tnangular relations between the new local governments,the public enterprises providing local services, and the centrl govenunenLt In some ways, it is not too much ofa caricature to characteriz the local government system now functioning in Romania as amounting to little morein fiscal terms than a conduit between centrd government and these enterprises (or relies autonomies, as they arecalled in Romania). If one asks: 'What do local governments per so do in Romania?', the answer at the presenttime is: Not much.' Excluding the rngj local govermnment expenditures appear to consist of littlo more in mostcases than minor outlays on social assistance, cultur, and gener administrative expenditures. Most servicedelivery activities have been hived off to the various mge. leaving the local government as a place that does littlemore than collect dog licenses and register marriages. These may be essential activities, but they do not requirea large revenue base - and indeed in many instances would best be financed by fees and charges (as discussed later).

- 36 -

109. In principle, of course, thern is nothing necesarily wrong with having local govenments that do notthemselves deliver out of thei own resours many services to local reidens, just as there is nothing wrong withhaving local govenments deliver nationally-finaced and naonay-detmned semvices to local residents (see latordiscussion) or with having most local sevice activities caried out by local public enterises with septo budgetsand managemmats. All these systems can be found in one country or another and may work perfectly satifctorily.Indeed, given the extrm degreo of cenhalizion characteizing the trsitional economies in the past, the presentsystem in Romania, one of the Ist of theso countries to reject the old system, may be not only acceptable butdesirable.

110. Nonetess, it is critical to the financial health of both the local govomments and local public enterprisesthat the precise elionship between the two should be set out clealy. At present, in a number of countries thalines distinguishing activities that should be performd by local gov _ents, local public enterprise, andcommercial enterps are undesirably confused. Unless these questions arm disentangled, senous problems mayoccur both in setting up properly functioning local governments and local public enterprise and with respect toprivatization more generally. A few examples from field work in several countries illustra the point:

In some areas, local governments are responsible for certain activities (e.g. parks); in others, localenterprises;

Some activities (e.g.bakeries) are commercial in some areas; others are nru as adjuncts to local publicenteprises;

It is also important to clarify the relationships between differant public enterprises e.g. at regional and locallevels as well as betwen enterpriss and governments, especially when an enterpnse is located in one areaand serves other areas as well.

:11. On the whole, municipal enterprises should be confinod to traditional local public service activities (waterand sewer, heating [traditional in eastn Europe, at least], tansit, perhps solid waste collection and disposal).All essentially commacal activities now conducted by such enteprises such as bakeries, laundries, and constructioncompanies should be sold off as soon as possible. Finally, in some instances certain activities (e.g. parks) for whichthere seems no appaent rationale for adoptig the enterpnse form of organiation should probably be folded backinto the local government proper.

112. Where it is decided to organize some local public service in the form of a public enterprise, any subsidypaid from generad local government revenues should be set on an ex ante basis to establish the hard budeet constraintneeded for efficient operation. Moreover, such enterprises should be subject to all normal tax laws (central andlocal), and in general they should be run like commercial enterprises e.g. setting prices and terms of services -although presunably within a natioally-esblished regulatory framwork (which as yet does not exist in mostcountries). At present, local authorities essentially have either no guidance in setting enterprise prices, or too muchguidance in the sense that these prices are still being set by centrd authorities.

113. The budgets of local public enterprises should also not be consolidated with local government budgets perse: only any explicit subsidy and any profits transfer should appear in the goverment budget. Of course, enterprisebudgets should be annexed to the local budget and submitted - not for approval but for information - to theappropriate cental agency, as noted earlier. Mhe numerous somewhat anomalous decentralized institutions foundin many transitional economies (e.g. Hlouses of Culture) should either be organized as enterprises and treated likeother enterprises or, if they are to be treated as component parts of local govenments, consolidated with other localexpenditures and revenues.

114. It is especially important, both for good govemnment and for good business, that local governments shouldget out of commercial business activities as soon as possible. The business of local government is not business, andthe sooner local governments begin to concentrate on their central task of providing as efficiently as possible the

-37 -

local public servi&as their inhabitats desir the better it will be for both busine and the local inhabitants.Although intentions in this respect are cleady good in most countries, there does not apper to be adquaterecognition of the danger of d lintion becoming an obstacle to the privaizton process, as is alreadyhappening to some extent in Hungary, Bulgaria, Russia, and pehas elswwhere (see later discussion).

115. As emphasized earlier, countries tat decentalize subntal expditure responsibilities to localgovemnmts that either do not have access to adequate local tax sources, or that are not capable (technically orpolitically) of admnting thos taxes to which they have access, run this risk, especially when sver fiscd crisesreduce central tanse to local governmnts. Whln the major source of governmnt rvenue has traditionally been,and is still to a lar extent, entrrse, the temptation for local govenmes to extract more revenue from thoseenterprise in thdir control can be overwhelming - and will invariably be most unforunate from an efficiency pointof view.

Provision of Social Services: Shiftina the Safety Net 'Downstairs'

116. Most public enterprises are engaged in providmg such 'hard services as water, electricity, and transport.In addition, however, particularly close attention needs to be paid to the role of local governments in te transitioncountries in delivering and financing services in at least three important 'people' areas - social assistance, health,and educadon.

117. First, while the present role of municipalities with respect to socid assi varies from country tocountry, being qmute restricted in Romania, for example, but much broader in Hungary, this are is all too likelyto become a major problem in all countries in the future as a result of two unpleasant but likely developments - theweakening of the naonal cacity to minin ociad protection at the present level and the growing need for suchassistance as a result of economic restuctunng. Even if the need for this bottom layer of the social safety netbecomes greater, however, it is far from obvious that the municipal level - while it may be the appropriate executingagency - should be responsible for financins such assistance. In many western countries, for example, it wasprecisely the unsusamably heavy load on municipal welfare systems resuldng from the interwar depression that leadto social welfare becoming mainly a national, rather than a local, responsibility. It is thus ironic, and potentiallydangerous, that so many transitional countries seem to be moving in the opposite direction just as the need for suchservices is rising sharply as part of the adjustment process.

118. Second, health and education are already controlled in large part at the local level in a number oftransitional countries. Experience in many countries around the world shows that people are willing to pay localtaxes to have their children educated. Hence, carrying out some education at the local level is one instance inwhich a devolution of expenditure responsibility may, at least in principle, be matched by a correspondingdevolution of financial responsibility. On the other hand, there are also strong reasons for central involvement bothin ensuring adequate investment in human capital throughout the country, regardless of local fiscal capacity, andto some extent in financing a higher level of such expenditure than localities would be likely to do on their own(See also the later discussion of trsfers).

Exnenditure Assinmment in Princiglo

119. . In the long run, a desirable assignmet of expenditures to local govermments in many transitionaleconomies might be something along the lines shown in Table 7, perhaps with the local' share being furtherdivided between different tiers of local government along benefit area lines. As Table 7 indicates, there are onlya very few functions - national defense, purely local services - that should be clearly assigned to one level ofgovernment or the other. Most expenditure functions are likely to be shared between levels of government, asindicated to some extent by the breakdowns shown for a few of the functions in the table: similar detailedsubfunctional categories could of course be set out for e.g. health and tansport.

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120. It is also importa to unstand that Table 6 refer to the level of govenumW dt a paticularservice. Who finM it is a diffent quesin. Moover, ther is no prsmption that any or all of thee sermust be Qgrducd by public setor agencies, although it is atuud that the public sector ust indeed to some extentbe responsble for thoe pgMjg of such services if anything clos to the opbtal mnmt is to ' a provided. Wbatmatters to people in what servces ar provded, not who provides thm. Ilded, may 'public sector' services arae-tually caried out by non-governmet ntities in diffrent comtries.

TABLE 7A Possible Ex=<diWur Amsin=

Local Center

National Museums XLocal Musem XCommunity centers X

Social Assistance X XMunicipal Services XTransporaon X XTelecommunications XHealth X

Educatic:n XKindergarts XPrimary Schools XSecondary Schools XHigher Education x

Protection:Local Police XFire Protection XNational Police xNational Defense X

121. To iUustate, aternatives to direct public production by genal-pose local goverments that may be foundin one country or another include:

* Various forms of contracting with prvate firms e.g. compeotive bidding for time-limited franchise (oftenwith the local govenment contiuing to own the assets, but turing to prvate sector firms - or possiblycooperatives of former public sector workes - to manap them);

* Establishing standards for required sevice and leaving it up to consmers to select private vendors and topurchase the required level of service;

* Issuing vouchers to (some or aUl) citizens and allowing them to purchase the required service from anyauthorized supplier,

* Contracting with other government units (e.g. disticts, other municipalities, enterprises, centralgoverment) to provide the serice;

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* Producig some seres, whilo purchang othm fiom other govenment agcies or pnvat firms;

* Estabishing on a voluntary basis limited (Oneighhorhood) govenmnts employing user charges (andposbly limited tax powers) to gsneate rveaue;

* Eblisbing limited-purpos ind dent govmentl unts cverng mom thn one general-pose localgovemn (spca disict) finnced by bnefiay chag of onemo or another,

* Establshing specia tax (imprve_t) ars within a given g -puros loca governt to provideservices to areas which are willing to pay for thm

122. Of course, the mer possibility of such varied augr nme to provide particular savica does not implyeither that these arangments will be easier to manage tha a mr conventional organizaton of public sectoractivities or that they will yield officient and equitable semce delivery. Noeltb s, one of the more strikingomissions in the on-going discussion of local govemment in the tranti eonomis is the fidure to keep straightthe cntical distinctions between who owns what, who Daynfor what, and who 4 whatL Contrary to the meagemany countries in transition sem to have absorbed from their prior expenence, namely, that ownership- iseveything, in the pubhic sector who owns an asset does not necessrily determine who regules the use of the asset,who opoaes it, or who finances it - and these fa ar, as a nle, much morm important in determining both whatis done, and what the fiscal and other implications are, than is ownership alone.

123. A striidng feature of local government finances in most trnsitional eonmomies is the prolifeation ofextrabudgetary funds (EBFs). In Hungary, in additiin to the lag national-level EBFs for social security, housingand solidaritya, thee are a large number of off-uidget accounts at the local level to which oarmaioe findsdevolved. Such 'inherited emarndg' is also a promint faotur in th CSPR. In Russ, the right to set up thesefnds was accompanied by the assgnment of a number of non-tax rvenu sou to local governments. Bulgariaand China so permit such funds to be st up, and in the latter thoy conatitute an important parallel budget at thesubnational level.

124. The geness of theso extabudgtay funds is complex. In par they rep t an attempt to escape the"control mehanism? of tho cantrl govenment. Insmuch as local budgets in some countries are not reallyautonomous and remain subject to smutiny from above, EBFs ovade this scruy on the expenditure side. Iacountries whoe the loca govenmments ae transfer- dependent, and whr transfers are allocated not by formulabut by bargaining and negotiaton, puttig rnsourcea off-budget into EBFs is a means of concealig the true resourcebase of the locality from the center. Some local governmmats themslves claim dtt oxtrabudgetary funds reduce theuncertainties of the budgetary process. Moreover, to tho oxtent the rvenue system remains basically unitary - thatis, the tax base and tax rate of most, if not all, taxes are defined by the center, with revenues allocated to the locallevel, EBFs may provide the only window for any local revenue initiative. Lastly, in countries such as Russia andChina, whero local governments must share any revenues they coUlct with higher level govemments, EBFs, beingoff-budget, are not thus shared, a fact which gives them considerable added attraction from a local point of view.

125. On the other hand, such funds present serious problem for effective budgetary magement at themacroeconomic level. They also reduce the tanwparency of budgetary operations and complicate assesment of theimpact of fiscal policy. In practice, extrabudgetay funds function as parallel accounting systems which, for allintents and purposes, basicaly constitute full paradll budgets not subjoet to the strictures of conventional budgetaryprocedures. In addition to being a clearly inefficient budgetary practice that permits public sector operations notlegally approved through the proper channels, the loss of control and information asing from the presence of suchmultiple budgets is bound to undermine the ability of the government to use fiscal policy as an efficientmacroeconomic instrument. Without discussing the specific merits of each EBF, as a geneal rule legitimate revenue

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sources should be fully incorpoated into thoe reulr budget to provide full accountability of fiscal opaions, andif this is not possble, full information about the sours and use of extrabudgetay funds at sub-national levelsshould be proWvided to the centrd fiscal authorities.

IV. FINANCING LOCAL PUBLUC SERVICES THROUGH USER CHARGES

126. Th prvious sction noted that in most trational cownomie many local public sector activities ar cariedout through public etaps. Such terpis ar coma., for example, in trort, in houng, in garbacollection, in watr and sewap, in electricity, and a on. Evae with prvatiuzato!a, my sch entrprises ae likelyto continue to exist in most countrias. The quesdon of how local public entepris arm to be fiaced is thereforeof critical importane to the health of the local public sector. The answer suggested by the benefit approach to localgovernment finnce outlined earier is tht as a genal rule, such enterpises should be self-financing, that is, theyshould be paid for by those who rceive the services they provide. To put this another way, the first rule of localfinanco should be: Wherever possible, charge.' For efficiency, chages should be levied on those who receivethe benefits: the direct recipients, whether businese or 'thingas (real property) should thorefore be charged.V

127. Although the ultimate incidence of such charges is of no more interest in principle thn the ultimateincidence of the price of cheese, studies in difforet countri have shown that the distributive conseqm c ofcharging for local public services is not necessrily regressive. In any case, attempting to rectify fundamentaldistributional problems through inefficiently pricing scarce local resources is almost always a bad idea, resultingin little if any equity being purchased at a high price in efficiency terns. As noted earlier, however, particular carewill need to be tken in adjusting local public service prices (including rents) in the transitional economies becauseof the important role such prices played in offecting distribution policy under the old regime.

128. While user charges are most likely to be viewed by hard-pressed local officials as a potential additionalsource of revenue, their main economic value is actually to gmoto economic-efficienv by providing demandinformation to public sector suppliers and by ensuring that what the local public sector supplies is valued at least

at (marginal) cost by citizns. This efficiency objective is particularly importat at the local governmnt level sincethe main economic rationale for local govemment in the first plac is, as noted earlier, to improve efficiency. Thereis thus a presumption that, whenever possible, local public services should be charged for rather than given away(unless, of course, they are pure local public goods or the explicit intention is redistributive).

129. For example, when local govemments provide services though local public enterprises such as water,power, gas, and public transit, these services should generally be charged for at prices that will recover the costof providing the service from the uses or buyers of the service either i;mmdiately or over time.2 The price ofwater should reflect the cost of piping it to the homes (or standpipe) as well as the cost of mantaining the pipes,treating the water, and so on. Bus fare should cover the cost of purchasing buses and maintaining and operatingthem. In principle, such prices should be set at the competitive private level, with no tax or subsidy elementincluded - except when doing so is the most efficient way of achieving public policy goals (and even then, as notedearlier, it is best if the tax-subsidy element is accounted for separately).

130. Unfortunately, in most countries much less use is made of charging at the local level than seems desirable,and many of the charges that are levied are poorly-designed from an efficiency point of view. Weak accounting

IZ'I view of the substantial importance of locally-provided intermediate goods to business, some limited localtaxation of business may thus be warranted, but, as emphasized elsewhere, it is important to constrin the abilityof local governments to *export' tax burdens to non-residents.

-there are, of course, many well-known qualifications to this statement, but it is sufficiently accurate for presentpurposes.

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systems that do not clearly identify costs is one reason for the prevalet under-pricing of these semces. Anotherrason is the historical hangover of the previous distributional role of such prices. And a third is the simple politicaldifficulty that newly-elected local goverments have inposing subsmtnt increases n srvce prces on thosewho have just electe them.

131. Lca governments also obtain revenue from *som&o fes uch as licens fes (mariage, busine, dog)and various small charges levied essenially for performig specific services - reg ng this or providing a copyof that - for identfiable individuals. In effect, such fes costitueost imbement from the private to the publicsector. indeed, in some budgetary systems, such cost twcoveries are neted out and only net (of recovenes)expenditures sowd Chargig people for something they are required by law to do may not always be sensible- for example, if the benofit of (say) regisation is general and the cost is specific -but on the whole there is soldommuch harm, or much revenue, in thus reovering the cost of providiog the service in question.

132. Another category of charge revenue encompasses what may be called *wgafic benefit taxes (or chures).'Such revenues are distinct from service fees and publie enterpise pries becau they do not arise from theprovision or sale of a specific good or service to an identifiable private individual. Unlike 'prices' which arevoluntarily paid - although like 'fee's which are paid for services that may be required by law - taxes reptesentcompulsory contrbutions to local revenues. Nonetheless, specific benefit taxes are (at least in theory) related insome way to benefits received by the taxpayer. In contast to such genel benefit taxes as fuel taxes levied on roadusers as a class or local taxes in general viewed as a price paid for local collective goods (see below) - specificbenefit taxes relate to the specific benefits supposedly received by specific taxpayers.

133. For example, if as a result of a new road, better street lights or a new sewer system, property valuesincrease, or busine sales dse, a 'benefit levy' might be introduced. This could tame several different forms; (a)a 'special as nt'; (b) a 'land value increment tax'; (c) an 'improvement tax'; and (d) a 'supplenentary tax',etc. Most such chargs are imposed either on the assessed value of real property or on some charateristic of thatproperty - its aea, its frontage, its location. A common benefit-related charge is the development charge (or'beterment tax') - a lump-sum charge designed to recover the cost of infiastructr developmet frombeneficiaries. Thus, those whose land is near newly-installed stet lighting would be charged to help pay for thecost of the iation. A development charge may cover only ono project-for example, a neighborhood roadpaving scheme or the construction of a sewage canal-or it may cover the full development of a new area. Sucha method of financing may be not only efficient but equitable, since those who benefit from development pay forits cost. Two paricularly successful systems of development charges are land readjustment in East Asia and the'valoriation systm' in Latin America. While such shemes are most obviously useful in rapidly-growing ubanareas, there may nonetheless be some role for them in at least some cities in the transitional economies.

134. In any case, the importance of charging for public services in these various ways is, as emphasized earlier,much greater than the relatively small amounts of money most countries can or do collect from such levies. To theextent that a local government is viewed primarily as a provider of services, as it should be, and the benefits ofthose services can be attributed specifically to individual citizens, properties, or busneses, the appropriate policyis clearly to charge the correct (roughly, marginal cost) price. Only thus will the correct amounts and types ofservice be provided to the right people, that is, those willing to pay for them. Correct pricing in this way helpspublic officials make sensible judgements as to how to match scarce resources with rising demand. When the truecost (and the related user charge) rises so high that demand falls, the costs of the service exceed its benefits in theopinion of the public. The signal is quick and clear. A decision is then needed as to whetier to: (a) increase theprice and serve fewer people; (b) cut back on the cost and standard of service to keep it affordable; or (c) subsidizethe service from general revenues. In the absence of such price-generated demand information, supply decisions canonly be made by bureaucratic rather than market-oriented processes.

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V. THE CHOICE OF SUBNATIONAL TAXES

13S. I es asil p upose of loal ta xs to fineo locally-provided collective public goods for local reidenIf such goods a tuly 'public in te ss of accnung equally to all rsiden of the jurisdiction, Mn ifedisribution to ote tha natna standards is not aim of local public policy, ad if admiisrative (adcompliac) cost am left out of accm , tho be ource of local mven migh prahp be an equal per cap levysuck theo 2LU, which aWs hs dke vitu of beg economially nautrl or officiet in the sense of givingto no exces buni

136. At loest an ounty, Huny, aclly has introdced a form of local poll tax, called eo taIn view of the high propot of publi housing in Hungay - a proportin dth will undoubtedly deli but is lblyto remai sigficant - an argumt c indeed be o for levying aome form of local poll tax an public hosingtents.W Altough tis tax my prove mor difficult to administer in Hungary's i ney mobile socie thansem to be geneally u_ lim h a tax, while it is n r liely to yield nuch rven, may thusbavo a minorrole to play in local finc From this persctvo, however, it would be prefble if te rate of such a tax woset locally rathe imposd unifoimly by n al legiooas in Hunguy. Although such differuatal localpoll toxes are eay to ovade by movig, tis pobiliy may be viowed - creaing a not undesiable check on theirrates. Of course, ven those who do not floe may be had to tax: the low officincy costs of th, poll tx m likelyto be purhasd at the expns of high admiittve _d compliance costs.

137. More fundamtlly, thoa is good n to beive tat in many coa some local renidets - porty-owners, people with school ag cbildn, or whoever - benfit more thanors frm the provision of local publicgoods. That is, while thee may be no ron to levy cfic benefit taxs thre may be good rson for some localresidents to pay m than otrs

138. If, for example, the deand for local public goods is incom laadic, a benefit cas can be made for a loalincome tx - or, more feasibly pehap given the high adminative costa of separate local icome t , a localsurhage on the cental income t& If the enoymet of such goods is amocied wi consuptin (rahe thanreddence), a benefit cas can dmilady be made for a oxl tax an consumption, which would in practice almostcerinly have to take the form of a rotil sales tax. And finally, if the benfits of local public goods ar enjoyedin proportion to the value of real property there is obviously a cas for a local propety tax.

139. Under-flmdnd. .md.EimJIy D _tdm? In practice, th fisca sitaton ficing most central govermntin transitional count is such tht vitually no major revenues we ceded to subsional govenments. Manycouns - esily those ith a stonmg regional tradition suck as Rsia and the formor republics- aig thetax revenues (other than the coporate tax) from locally owned enterprs to the local government, givUg themstrong cntlisntc incetives to protect ad maitai the monopoly position of ter entepis. Thi is likely tohave cosequences for futre economic growth, especially where localities arn swcessuy 'protctiniat. In mnyof the countrie surveyed, the strong financial interest of local government in locally owned enterpris rm .This is a holdover from the old fiscal system under which enterpnse profits accrued to the level of govemnt thatowned them (i.e. profits of locally owned entuprises weA to the local govenment; profits (and later, taxes) ofcentrally owned entprises went to the central government; and provincial govemments received the profit oftheir enteises).

tt is of course asumed that any desired general income support is provided primarly through national sources:as argued earlier, local goverments should not misprice their servces for distributive reasons.

&Such a surcharge is, for example, proposed in Bird and Wallich, 3Financing Local Govemment in Hungary. a andin Wallich, Fiscal Decentralization:Interovernmental Finance in the Rusian Federatio.' See also the lterdiscussion in this section.

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140. Of all the countries surveyed, only Hungary and Russia give subnational governments as large share ofcertain non-enterprise revenues. In Hungary, local governments get a share of the personal income tax (PMI -initially 100%, then 50%, now 25%. In Russia, subnational governments get some 20% of VAT, 100% of PITand 60% of the corporate profits. More generally, in most of the former USSR republics -the present CIS - thepersonal income tax is assigned to the subnational level, a holdover of the old Union days in which the PIT wasa "local tax' assigned to the oblast level and passed through to rayons/cities. Generally, subnationai govermmentsin transition economies are under-funded, and overly transfer dependent (See Tables 8 and 9).

141. The only 2tentiallv (but not preseatly) significant tax these countries have assigned directly to localgovernments is usually the 29z txJu, as in Hungary, Bulgaria, Poland, Romania, and Russia. In Romania, forexample, the property tax is levied on all privately owned real estate. The tax rates are differentiated and, in anundesirable carry-over from the old rgime, varied with the 'social characteristics' of the property owners: 1% onthe value of the property in the urban area owned by workers and employees of commercial societies; 1.S% on thevalue of property owned by individualbusiness like independent professionals, self-employed individuals, and familyassociations of ro more than ten employees; a lower rate of 0.7S% is levied in rural areas. The taxable value ofproperty is reportedly based on inranco assesmnents, sales contracts and construction costs and appears as a ruleto be grossly underestimated. Moreover, all buildings owned by public institutions are exempted from this tax and,in another featue seemingly guaranteed to keep the yield of this tax low in a country privatizing its housing stock,all houses and apartments bought by individuals from the state are exempted for ten years. Even apart from thisserious structual defect, the difficult and costly task of updating property valuations (and keeping them current)means that while this tax may become an important source of local revenues in the long run, it would appearmistaken to rely on it for substantial revenue in the near future.

142. Matters are not much better in Hungary, where the property tax is levied at a more uniform rate - 3 % of"corrected sales value' (which usualy means about 25% of market value) - or, alternatively, at a flat rate per squaremeter. As a rle, the only information local governments seem to have in practice on which to base such taxes isthe area - and even with respect to area the exemptions specified in the law (and carried over from the old system)ensure, as in Romania, that not much revenue is likely to be collected from this source for some years.3"Substantial national assistance in developing an adequate valuation base seems necessary if the property tax is tobecome an important component of Hungarian local finance.

143. Another tax granted to local governments in some countries has been the old tax on individual business.essentially an income tax on small private enterprises. This tax has been assigned to localities in Romania, forexample, on the grounds that it is easier for them than for the central government to check and collect such a tax.With increasing privatization in urban and rural areas, it might appear that considerable revenue might be expectedfrom this tax. In fact, however,even in cases where, as in some larger cities, there are already computerizedsystems of information on tax bases, tax rates, exemptions, population and family structures, it is by no means clearthat it will be easy to keep these data bases up to date, as economic activity moves increasingly out of the directcontrol of the govemment. For small communes in rual areas, family visits by tax collectors are now the mostcommon way to collect direct taxes in many transitional countries. Again, however, it is unclear how much weightthis system - which grew up under and was long supported by the totalitarian regime - will be able to sustain in themore democratic, and less controlled, circumstances now prevailing. In any case, with the growth of the private,and especially the informal, economy, the level of evasion with respect to local taxes seems more likely to rise thanto fall over the next few years. In reality, experience throughout the world suggests that the only kind of businesstaxes local governments can collect efficiently are low-rate and relatively crude levies.

L There is little to be said for using area as a basis for urban property taxes. The case in different in rural areas,however, where taxes such as that in Romania - a differentiated rate ranging from 35 lei to 400 lei per hectare,depending on ferlity and location - may make sense, provided the present fixed per hectare levies are adjustedannually (or more often) in accordance with an approprate price index. Unfortunately, those who have receivedland under the land reform are exempt from land taxes for 8 yean in Romania, thus severely weakening thispotential source of local revenue.

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Tabl SRevme A _ime to Submiol Authorties

_____~~~~~~~Ri -_lonkR. _~ _ -- u -__Hungar Polan Romania Czech R. Slovak a. asiml Vi etam) guia 11,1,inse(1991) (I991) (19"l) (1991) (1991) (195) (1991) (1991) (19)

Trover tax (er VA) L0 0 N.I. 100% 100% O /fi 20%CTruoqte incoA tax 0 X 0 N1 N.I. IOO% 100% 50X/ _ _60%Peuionl ome itax 25% I/ 30%_/ 0 N.I. N.l. 100% 100% 70% 100%Tx on Ppetty of 0 100% 95%2 / SO IO tO 0 V-. 100%Lcally Owned SOEs -I 0 _ _Exciwes 0 0 N.I. N.L 0 0 61.1%Wage tax 0 30%I/ 0 0 13% 0 0 0Small and Medium ErAJ N.A. 50% 0% N.L N.L 100% N.L N.L NA |Collves bnome taxLocal Taxe: _- real es tax 100% 100% 100% 100% 100% N.L NJL 100% 100%- autolroad tax 100% IOOX 100% N.L N.L N.l. Nl. N1 100%- s1ma busisa 100% 100% N.A.L N N.L NX. N.L N.A.- agricultural tx 0% 1OX% 100% N. 100% 100% 100% 100% NA.- pon tax 100% N.A. N.A. NAL N.A. N.A. N.A. NA. N.A.Natuml Reaauce Tax N.A. N.A. N.A. N.A. NA. 100% N.A. NA. 100%Odiet touim & mis. Mile. NA. N.A. N.A. N.A. NA. 21 misc.

misc. taxes

Soume: Misc. BRD domaents. See biligaphy.Noe: jI Reduced fom 100% (1990); 50% (1991).; 3/ Unot 1M tax eform.; I/Alo coaidad as property income tax.; if Tobe abo le in 992.; 11 To be usneftmned istoa mmr effectivePN in 1992 and hared according to a 85X (cexral - 15% (ocal) traio.; _I To be inrodud in 1993.; 2/ 100% of ech tax acnus to die le of goveetneutownigth end eprie; eg. VAT pddby provinciafy owned SOEs accrues to the pvincial budgd.; I/ 40% from unkiipal enterprises and 10% from stente pries.; NJL: No hfomation.; N-.: Not aplicable.

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144. Just such a tax ha been creted in Hungay in the local tax on busnor. Unfortuately, this isa bad tax. Although the pesnt low rate (3 per mill) on business tumover is not likely to do much ecomiicdamage, such a cumlative busuie tax of course poduces precisely the s- kind of tax cascading an Hugaryhas tied to eliminate at the naiooal level by adopting a VAT. This problem will become more srious if, a islky, the increaing prsu on local finace leads to inea in tax rates in the future. Moreover, a premulydesigned (with the explicit exclusion of retil sleo fiom the tax base) this tax encoraes both tax exporting andlocal attaemts to maipuate the tax sysmI for incentive reasons. Tax exporting is of cours the antitheis ofaional local finance, and local fisca ;entives to production have a dml record tumghou the world, so nehr

of thes features of the tumover tax is desirable.

145. Another bd tax that has apped in a umber of countries is some form of local Ourist. Touitestablihmt (inluding second homs and cotta) should of couse be suvi*act to geneal local bunes andproperty taxes. And of coumes should be chaged fully for the costs they im on the envinmet ad on localpublic services. But tde seem no reason to encourage fiscal irsponsibility by maling it especia y aractive forlocal govemments to imprse taxes on noresidm: as a nle, they need to be restrained from such actions, notencouragedl.

146. Another possible local govenment tax, in contrast, deserves more atenion than it seem to have so farreceived in most trsnsitional economies: the taxation of motor vehcls. At present, it appers that only about 7 %of vehicles in Hungary, for inance, ar subject to the relatively small and not particularly well-desiged *dutieslevied by local gover_ments., Many counties similaly have widepd exemptions from their exing vehicletaxes e.g exempting not only aU vehicles used by public institutions finnced by the state but those used by warveteran and so on. None of these exemptions, of cours, mo.m any sene given the basic benefit rtinalo of thistax. As vehicle ownersip beomes more widespread vebicle taxes (tedesigned to be less vulneable to inflationand perhap more in line with envirnmeta needs) might in timo become an important revenue source for at leastthe larger localities. In principle, ul vehicles should be subjwcted to taxes designed to some extent to offset thesocial costs attributable to vehicles. While such taxes should probably be dosignd and imposed uniformlythrughout the nation to avoid obvious administatve problems, there is no reson why these revenues should notbe assigned in whole or in part to the local governts in which the vehicles ar registered.

147. Although both vehicle taxes and espocially the property tax clearly have significant long-term revenuepotentid, particularly in larger urban areas, on the whole the local tax packge bestowed on local governts inmost transitional economies leaves much to be desied. Often, for example, local tax rates and tax bae areestblished in central govemment tax law, and at most a range of rates is provided within which local govenmtscan choose. Many of the taxes thus established have rates fixed in nominal cunmcy, thus making them highlyvulnerable to erosion through inflation. Others are minor nuisance levies which may weU yield less in revenue thanthey cost to colect. None pi .ides an adeque fihcd foundation for an active and viable local goverment

WIt has been argued that tounsm taxes (krtaxeon or taxes de tournse) should be seen more as a globalized usercharge than a fiscal levy. Resorts with annually widely fluctuating populations have to assume expenditure, bothfor operations and capital investment, of a type and amount that cannot and should not be recovered from the (oftenfew) permanent residents but from the acual beneficiaries of these services. If not, the unavoidable consequenceis that resort areas turn to the central government with a demand for increased fiscal resource transfers and that atthe end tourism activities get, in one way or another, subsidized by the central govenment as, for instance, happensin Turkey.

ain Romania, in another undesirable hangover from the old regime, initialy, some motor vehicle taxes (levied atflat ates, by type of vehicle) went to the central govenment, depending on the nature of the taxpayer. SinceAugust 1992, these now go to municipalities (individually owned cas) or to disticts (cars owned by corporations).

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148. In moms counries (me Table 5) at preen, all the ceal govenumt ta ar collected by a _ dJjtax Although sich dual loyalties can obviously caon problems, it soem unlikluy that bhvig locltaxes collected by local governzmnt will help mtters muck in the r fture, given te sevee so of tridtax adui_nor. In Vietnam, the MOF ha eblished a Geeral Tax Deatm_t to ovetsee the aciVitie of a11provincil tx d_etmu. in China tha amr two orguai-mn: the Tax Bureu and tie Fiac Depatmn whichhave sparae d _atmt with detiled functio at each level of city, county and province. Rom is ao anthe procos of crating two orgatios to hndlo fince and tax admintaon at the local a woe a ntnlevel. in Russia, tax admnitration it responsibilityof te Stae Tax Semrice (STS) which hu an orgaionalsucur at all throo lvela of govem t, and is an saunomou agecy with initial rning.

149. A *uy JItrx miht pehop be dfnd one (i) aseosd by local gover t, (ii) At rte decidedby local gvota, (iii) collected by local govanins, and (iv) with its poceeds _auing to local gov bnts.In the ral woldd, however, many taxes possess aoly one or two of hes charactstics. In sm cases, foroxample, a tax accros in whole or in par to local govemnts, but its re ae sot by tho ntionl gpv _nit,which also asoss nd coUects it. Insted of a local tax, for many puposes suh a tax might be conidered tobe really a cental gvenint grant allocated to local gove_nnts in prportan to the amount of natiOna in)ometax colected locally. On the otdr had, what looks like a cntral tax and a rlated tafr proa m reyalybe a local tax. Some i ovrl trasfe, for example, in effect smply rer taxes to the regios in whichthey wero collected in the first place. If the local govermet detmn the tax base and rate and receives all thervenues, the only role th cntal goverment plays is a a collection agen: it may even be rembud for itsworc, for ince, by beiong allowed to reta a sal percentage of coUctions. Proe bly, the cntrlgover_it ha a comparve advantae in tax collection, and the local govenunet has conacted for its servicein this reopect. In this case, there is no intergovenmntl tranfer at all, except in tho narrowest accountng ss.

Characteristics of a Goo Loca Tax

150. The following are among the chaacteristics that may be sought in an 'idedl local tax:

[1 The tax base should be reltively immobile, to allow locd authorities soms loony in vaying rateswithout losng most of their tax bas.

[21 The tax yield should be adequate to meet local needs and sufficiently buoyant over timo (i.e., it

should expand at least as fast as expenditu).

[31 The tax yield should be rlaively stable and predictable over time.

[41 It should not be posible to expost much, if any, of the tax burden to non-residit.

[51 The tax base should be visible, to aesur accountability.

[61 The tax should be perceived to be reasonably fair by taxpayers.

[7 The tax ould be relatively easy to admns efficiently and effectively.

Not everyone would agroe that all those charcteristics are necessarily desirable - e.g. is it unequivocally good that

local govements should be insuladd from either the tax base consequcs of their tax rate choices or from

inflation? In any case, it is unikcely that sufficient taxes possesng most of the c _aestics will be md

available for locl use. In fact, as already noted, the so-cailed "local* taxes in most trnstion countries arecontrolled in varying degrees by cental governmmets e.g. with respect to the deermintion of tax base, tax rates,

and/or tax aminisa Noneteless, unless ther is a significant degree of 122 freedom of choice with respect

to some or all of these matters - so that local govenments can change the level and conosidtion of their rovenues -

it is not very maningful to talk about *locl autonomy. a

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LAA vt Taxes

151. How doe te pmprty tax score in the tus? In t firs pace, a experica in a number of cowiesha sow in nrcet yea, theres often wideopred resistance to the poperty tax whe too muh veue is soughtfrom this soumc. One mum is prcisely becauu it is a very visble tax, for vl reaso. First, ulie theincomn tax, the popery tax is not deduct at ouce but generally ba to be paid dicly to the nundiciplity bytxpaye i periodic lump vum payments. Taxpayeo who pay taxes directly to goveant tend to be mo awarof the size of thiir tax bill th thos whos tke-hom pay is eduoed by wedky or montly tax deductions. Mmneed to make such penodic larg paymint ny woU add to th accouiHtbty a reposbility of localgovemint, but it alo gry incrums the nmativity of taxpayer. to even noinal inces in taxe.

152. Seooodly, the ineltcity of the property tax ha a smilar effcL Since tho bas of this tax doe not ua rule mcra autonacally over time, the penodc nominal incs i property tax bills needed to mintainel reoven whe price levels rie reqr inad tax rat. In tunn of political accountability, tis need toconfront the people with the cost of govenint again reprents a vitu of the property tax; agin, however, thodownside (from the local government's point of view at least) is the heightmed visibility of nominal tax increasesand the accompanying political resstance.

153. Thirdly, local proprty taxes of course finance such municipal servicae as ducadon, roads, and grbagecollection. The quantity and quality of thee servicas (or their absnco) is thus readily linked to the prperty tax.When potholes devlop in their eet, taxpayers are nd daly quick to question the taxes that supposyfinance stret pir. Once again, the very faor that makes the property tax a good source of local govermentrevenmu in piciplmoa it ospecially vulnerble to political restance in ptce.

154. Oter problems result from prperty tax administrton. As a nle, property is supposed to be aaosed anthe basis of its maret value, usually defined a the prce struck between a willing buyer and a willing sller inan arm's length trnsaction Exacdy how this is to be implemented in countries in which private propety is in theprocems of beig established in law for the first time in decade is not anirely clear. At the very least, therw is asubstantial valuation task required before much fiscal yield can realistically be expected from propert taxs in mosttransitional economes. Moreover, even in countres with well-developed property tax systems, discrepae usuallyaise beween messed values and markt values within classes of property, between classes of property, and across

unicipalities for both political and technical reasons. Since taxpayers can easily compare their propeaty taxes wi=ththose of milar pwperties in their neighborhood, such discrepancies lead both to spocific asse appeals andto general parsr for tax reief.

155. In short worldwide experience suggests that there are at least thre substantial constraints on the use ofpropety taxes for local finance:

*First, although the administration of the tax can certainly be improved in the tannsition countries,there wil always remain sver problems in administering it in a horizontally equitable fashion,particularly when prices are changing rapidly.

*Second, the temptation to the inevitably rather fragilo new local goverments to indlge inpolitically painless but economically inefficient 'tax exporting' means that severe constraintsshould be placed on the degree to which local goverments are permitted to tax busineses moreheavily than residential taxpayers if the property tax is to be an economically desirable sourc oflocal revenues.

wrhird, both becausn of its fults and its virtues, heavy reliance by local goverments on theproperty tax probably ensures that, as is the case in most countries where the propefty tax is themain local tax, they will either continue to be heavily dependent on intergovenmntl grants tofinance their activities, or they will not carry out many actvities.

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156. D it these politicaland adminisaive problem, the promty taremains a potaly sigificntsourcof revenue for local govemments in trnsitional countries. Moreover, there ae good reasons for taxing realproprty both a a local tax and as a tax in genal. A tax on rel propety may, for example, mao good oseas part of th tax system as a whole: although relivoly expensive to adminiter, such a ta scores quite woe interms of both its efficiency and its equity aspects. Moreover, if loeved at the local level, a pperty tax can, asempized above, seve as a good men of fnacing local public goods - subject, however, to three imp_ontprovisos:

(1) An adequate nationl fmwork law is estblhed (to prevent unwarranted local manipulatioof the bas and rate suctu and in particular undue loading of the tax burde on nonsidmns).

(2) Loc govermmnts ore providod sufficient technical upport to carry out their ed of theadministrative process (which should probably not include valuation).

(3) Local gov remnts are pemitted (within the paramte set out in the framework law) to vaythe tax rate anmually. Such rate flexibility is esetial if the tax is to be adequately responive tolocal needs and decisions.

Unfortunately, none of the proprty taxes recently creed in the trnsition ecanmies apper to atsfy thescritnia.

Own Subnational Taxes versus Shared National Taxes

157. On the whole, if there is an obvious alternative (or supplement) to propety tuaxs it is likely to be someform of local income tax, probably levied as a supplement to national income taxes. The cas for rdying onproperty tas, especially taxes on residential property, as an importat soumr of local govemment finance strong. Since, however, property taxes can only be pushed so far, if more local 'own-source' rvenue is desired -- either to expand the size of local activities or to make local govemments more self-reliant - thr is much to besaid for supplemtary ('piggybacked') local income taxes.

158. Of cours, property taxes do not even come close to financing the needs of the subnational sector wherethese have sgnificant expenditue responsbilities. Thus, in some countries, notably Russia - wher the subationalsector fina close to 50% of public expenditur - access to major national taxes, probably the pernl inconmtax, will be needed.

159. Like the property tax, such a tax, if appropriately designed, would be visible and hence in principle stisfythe criteria of political responsibility and accountability. However, the fact that income tax revenues tend to growwith less political fuss, while presumably good news for local officials, suggests that ineas reliance on localincome taxes might be viewed with mixed feelings by some. On the other hand, since an income tax is usuallyperceived as more progressive than a property tax, it scores higher than the latter on equity goWunds.

160. The principal argument against local income taxation is administratve. Most of the other argumentssometmes raised against this proposal have no merit. One such argument is that there is sometiing inherny *badin efficiency or equity terms about allowing local govemments direct access to the income tax. Some localgovernments, for example, probably have no income tax base. It might therefore be argued that it is somehowunfair or inequitable to let those local governmente that have such a base exploit it. But the logic of this agumetis not apparent (and of course the basic unequal distribution of local tax resources is procisely what the equalizationgrants discussed later are designed to deal with).

161. Similarly, arguments that local income taxes reduce national fiscal flexibility or induce inefficient fiscdcompetition or inefficient resource allocation are at best incomplete and in general misleading. The functions localgovenments are supposed to carry out are essential, these expenditures have to be financed somehow, and the local

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income tax approach seems more likely than most alternatives to free the national government from the responsibilityof financing some such services while still leaving it a free had to alter its own tax system as it sees fit.

162. Moreover, assuming the benefit' model of local government postulated abovs is followed, such taxessimply constitute the price of local public services and have no adverse effects on resource allocation or on fiscalcompetition. On the contray, their allocative effects are desirable as is any competition they may induce amonglocal goveombt in lower-cost provision of desired public services (including the intermediate services enteringinto production functions).

163. Whatever merits swh arguments may have, the prevalence of plans for local saresh in national incometax revenues in countries such as Hungary and Russia probably reflects more the influence of the historical paternunder which the revenues (like the expenditures) of both levels of government wOer unified than of economic logic.In Hungary in 1991, for example, localities received S0% of the revcnues collected from the personal income tax,allocated on the basis of residence. These funds accounted for about 13 % of total local revenues.

164. An alteroative to the Hungarian sysem would be to allow local governments to impose their own incometaxes in the form of a surcharge on the national tax.2' This option has two unique advantages:

*It is likely to lower the level of income taxes in Hungary without exacerbating the budget deficit.

*It is also likely to induce more efficient local expenditure than would otherwise be the case.

Such advantages do not come costlessly, however. The major argument against this approach is undoubtedly thatit would be relatively costly administrtvely and in particular would render the alredy difficult task of efficientlyadministering the national tax system even more difficult. Nonetieless, the prospct of achieving both a moreefficient (and democratic) system of local revenues and expenditures and a more efficient (and lower) level of totalexpenditures and taxes is sufficiently atrctive to suggest that this option deserves careful consideration.

16S. This proposal could be simply implemented in Hungary: for example, cut the national income tax by SO% -the share going to local governments in 1991 - and allow local goverments to impose a flat-rate surcharge on the

(remaining) national income tax, to be collected by the national govenment and remitted to the local governmentin question. Local govemments would thus continue to have access to PIT revenues, but now they would have toface local voters and justify their local income tax rates. In all likelihood, many local governments would initiallychoose to levy lower taxes (surcharges of less than 100 %). The result would then be to lower both total taxes andtotal expenditures, since the total amoumt local governments have to spend would be lower to the extent they levyless than a 100% surtax.2y In order for local governments to justify levying taxes as high as (or higher than) thoseforegone by the national goverment, they would presmably have to be able to demonstrate to their voters that theyare spending the money efficiently and in a dsired way. Suwh a check on local spending seems especially desirablein a situation like that in Hungary tcday in which central transfers are likely, for political reasons, to remainbasically unconditional.

166. Allowing local govermments to impose such income tax surcharges has at least two major advantages:

IfSee Bird and Wallich,'Financing Local Government in Hungary.'

M'Of course, this exposition abstracts from the possibility of local borrowing as well as local exploitation of businessenterprises. As noted elsewhere, however, local borrowing should in any case be tightly regulated and controlled,and local recourse to business enterprises for revenue purposes should be heavily restricted.

e so -

(1) Local govermments - at least the richer ones - will have access to a broad tax base so that theycan more adequately finance out of local resources the extensive range of services they aresupposed to provide.(2) Whether taxes go up, down, or stay the sam, the accountability of local governtnts, andthe efficiency of their expenditurs, should icrease.

Assuming the functions local goveranmts are supposed to carry out are essential, the local income tax approachseems more likely ta most altenatives to free the national governmnt from the responsibility of financing somesuch serv-ces while sdll leaving it a free hand to alter its own tax system as it sees fit. The altenatve of localsurchargus on value-added taxes or on enteprise income taxes are much less desirable on both techmical andeconomic grounds.

VI. THE DESIGN OF IPTERGOVERNMENTAL TRANSFERS

167. Russia, China and Vietnam are the only transitional countries with no explicit arrangment forintergovemmental transfers. In all three countries, there exist upwartd transfers' from provinces to the cenulgovernment. In most other transitional economies, while transfers ar generally the most important source of localgovernment revenue, most such intergovernmental fiscal flows are basically discretionary and "negotiated in natue.The exception is Hungary, whero there is an explicit formula for the so.called normative grant." A somowhatsimilar grant formula is currently under consideration in the Czech Republic. In Russia, where there is an ad hocintergovermental grant, there is no evidence that it is equalizing.

168. In themselves, transfers are neither good nor bad. what matte from a policy perspective are their offelcon the outcomes of interest, such as allocativo efficiency, distibutional equity, and macroeconomic stability. Anadditional essential element of an adequate system of transfers from the point of view of both centrl and localgovemments is Sau!parm=xy as when the transfer system is driven by rules or a formula rther than bydiscretionary political decisions. It is clear from Table 9 that in most countries subeational govements are highlytransfer-dependant. On avenge, some 70% of revenues, and often more, comes from trnsfers. Generally speaking,the concept of grants for capital finance, matching grnts and other standard approaches are little known.

Closing the Fiscal Gan

169. Intergovernmental fiscal transfers play several disit roles in most countries. In the first place, suchtransfers generaly constitute the principal way to achieve what is sometimes called 'vertical fiscal ballance, thatis, ensure that the actual income and outlay of subnational levels of govermment are approximately equal. Forvarious reasons, both economic and politica, central governments usually have much greater revenue-isingcapacity than do local governments. One way to transfer some of the revenues accruing to the center to financethe deficits of lower levels of government is through intergovemmental tansfers. Of course, such fiscd *gaps'may also be closed, and vertical fised balance restored, by trsferring revenue-raising power to local govermments,by transferring responsibility for expenditures to the central goverment, or by reducing locd expenditures or raisinglocal revenues. In virtully all countries, however, there invariably remains sufficient mismatch in the revenuesand expenditures assigned to different levels of government for an important 'balancing' role to be assigned tointergovenmental fiscd transfers.

EqaBlization

170. Equally important in determining the role and design of transfers is what is called 'horizontal fiscalbalance" or equaization. This is a controversial policy objective in many countries, and the design of such transfersrequires carefil thought. The basic economic case for such 'equalization' transfers shculd be understood clearly.On the one hand, such a trnmsfer may be needed to enable 'poorer' local governments - 'poorer' in terms of theircapac;ty to raise resources out of local taxes imposed on local residents (and not in terms of how high the private

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Table 9Stuc,ture of Subnational Government Finance

(recent year)

_ _

Hungary Poland Romania Czech R. Slovak R. China* Vietnam Bulgaria RussiaOwn Resources 18% 50% 25% 2I 9% 71% 15% N.I. 4.4% -Sliared Tax 13% 25% 0% 6% 4.7% 85% N.J. 49.4% 95%

Total Local Resources 31% 75% 25% 15% 76% 100% N.J. 53.8% 95%Transfers from Centrl Government 68.5% 25% 75% 85% 24% 0% N.J. 46.2% 5%

Souce Mic.IBRD documents. See biblio-gf-apu -Notes: 1I 51.4% as grants and 17.1% as Social Security Funds transfers.; 2/ Expected to decline to 20% in 1992.; ' For 1985. Also transfers not separatefrom aggregate figures; deemed negligible.; N.J.: No information.

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incomes of those residents or the output of the locality may be) - to respond adequately to central transfers intendedto generate the appropriate level of public goods (as discussed below). On the other hand, an equalization transfermay be needed to enable govemments that are poor in the sense just defined to provide an adequate 'minimumbundle' of local public services to citizns. The argument in this case, similar to the familiar 'basic needs'argument, is broadly that all citizens should be entitled to some basic level of such services, regardless of wherethey happen to live.

171. If horizontal fiscal balance is interpreted in the same 'gap-filling" sense as vertical fiscal balance,equalization implies that sufficient transfers are needed to equalize revenues (including transfers) and the actualexpenditures of each local govermment. Such "fiscal dentistry" makes no sense, however. Making up al gapsbetween actual outlays and actual own-source revenues for all local governments, like equalizing the actual outlaysof local governments in per capita terms (that is, raising all to the level of the richest local govemment), ignoresdifferences in local preferences for public and private goods and thus vitiates the basic economic rationale for localgovemment in the first place. Moreover, such extreme equalization ignores local differences in needs, in costs, andin own revenue-raising capacity. Finally, equalizing actual outlays clearly discourages both local revenue-raisingeffort and local expenditure restraint, since under this system those with the highest expenditures and the lowesttaxes would get the largest transfers.

172. For these reasons, in all countries with formal systems of equalztion transfers, the aim is either toequalize the capacitv of local governments to provide a certain level of public services or the actual performanceof this level of service by local governments. The performance criterion, which adjusts the transfer received inaccordance with the need for the aided service (and which may also allow for cost differentials) is in principle moreattractive to central governments - or those concemed primarily with the provision of certain services such aseducation or social assistance - since the level of service to be funded is determined centrally and the transfer canbe made conditional on the provision of that level of service. Unfortunately, this approach suffers from the samedisincentive effect on the revenue side as equalizing actual outlays, since that goverment which tries least againgets most - unless adjustment is made for differential fiscal capacity.

173. In principle, then, any sound design for equalization transfers pivots on some notion of revenue canacity.At one extreme, the aim might be to provide each local government with sufficient funds (own-source revenues plustransfers) to deliver a (centrally) predetermined level of services. Because such capacity-based transfers aregenerally based on measures of ootential revenue-raising capacity and not on actual revenues, no disincentive tofiscal effort is created by this approach. Differentials in the cost of providing services may or may not be takeninto account. Of course, transfers based solely on capacity measures do nothing to ensure that the recipientgovemrnments will in fact use the funds they receive as the centml govemnment might wish - unless, as noted above,receipt is conditioned on performance (and compliance is monitored in some way).

Fiscal Effort

174. While the evidence on the effects of transfers on local fiscal effort is far from clear in any country, thereis some empirical evidence that transfers often tend to discourage such effort. Nonetheless, it is generally not a goodidea to include an exlici fiscal effort element in a transfer formula. Suppose, for example, that a transfer is madedirectly dependent on the relation of the effective tax rate in the recipient municipality to the average nationaleffective tax rate. One problem with this proposal is that the measurement of fiscal effort is considerably morecomplex than usually seems to be realized - even if, as suggested earlier should be done, local govemments arelargely restricted to non-exportable taxes. If, for instance, tax bases are sensitive to tax rates, then the usualmeasures overestimnte capacity in low tax-rate areas (and hence underestimate the effort needed to increase taxrates) because the base will decline if the rate is increased.

175. More importantly, putting too much weight on fiscal effort in allocating grants unduly penalizes poorerareas, in which, by definition, a given percentage increase in effort (as usually measured) is more difficult toachieve. The problem giving rise to the need for equalization in the first place is that the capacity (tax base) of poor

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areas is too low, not that their tax rates are too low. Most fiscal effort measures inevitably reward the richerrecipient governments, which find such tests easier to meet. Imposing such an additional penalty on poor regionsin a transfer program that almost invariably falls far short of fully equalizing fiscal capacity seems hard to justify.

Matchino Grants

176. A final component of many transfer systems is what is called a matching (conditional) grant, in which thecentral governumt pays only part of the cost of crtain expenditures carried out by local governments. (At theextreme, where the cental government pays all the cost of work carried out by a local governmnt acting as itsagent, what is really happening is of course simply cgot reimbursement.) Several r-ionales for such transfers maybe distinguished, each with different implications for program design, as discussed below.

177. Matching gants in principle have important economic and fiscal advantages in terms of both allocativeefficiency (spillovers) and the efficient use of scarce centrl govermnent resources to attain desired levels of certainservices. In addition, while of coure rendering local govemments more susceptible to central influence and control,matching grants may have the inportant political advantage of introducing an elemnent of local involvement,commitment, accountability, and responsibility for the aided activities. Moreover, properly-designed mathinggrants may contribute to equalization (horizontal fiscal balance) and, like all other transfers, they help to resolveany basic fiscal mismatch (vertical fiscal balance) problem. Such grants may be particularly important with respectto capital investment projects (where they may substitute for, or supplement, subsidized loans).

178. The rationale for matching grants with the strongest basis in the economic literature is that the benefits fromthe local activity in question may spill over to other jurisdictions, that is, provide benefits to localities other thanthose which decide whbther to undetake the activity. Since such externl benefits will not be taken into accountby any particular local governmet in deciding how to spend the funds at its disposal, in general too little suchexternality-inteansive activity wil be undertaken unless the local government receives a unit subsidy just equal to thevalue at the margin of the spilover benefits.

179. The correct matching rate (m), or the proportion of the total cost paid by the central government, is thusin principle set by the size of the spillovets. This rate may decline as the level of expenditure rises, if theexternalities diminish. It may also vary across localities if there are reasons to expect greater externalities in someplaces than in others or if there is reason to expect a higher local price elasticity of demand for the service inquestion in some a&ss as opposed to others. Basicaly, however, a matching grant program designed to encouragethe optimal provision of public services would be expected to vary primarily with the nature of the activity, that is,depending on the level of associated extenalities.

180. Since no country has achieved full equaeization of local fiscal capacities, a uniform matching level offering,in effect, the same price to different local governments wil discriminate against poor regions. Indeed, even ifrevenue bases were fuUy equalized, thetr might stdl be grounds in terms of need or cost differentials for includingan equalization element in matching grant formulas. For example, per capita grants for roads in sparsely populatedand mountainous regions should generally be larger because the per capita cost of achieving any particular standardof road service will obviously be higher.

181. A quite different rationale for matching grants may arise from the existence of a centml government budgetconstraint. If the central government wishes to use its scarce budgetary resources to attain given standards ofexpenditure on certain services provided by local governments, it should pay only as much of the cost as is neededto induce each local govermment to provide that level of service. With a grant of m percent of cost, the effectiveprice to the locality is 1-m. To ensure maximum total (local plus central) expenditure on the service in question,given the size of the centml govermment contribution, the optima way to allocate a given total transfer amonglocalities will then be inversely to the price elasticity of local demand for the service (assuming no cross-priceelasticity effects).

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182. Matching grants should as a rule be inversely correlated to the income level of the recipient govenmment.The purpose of such transfers is essentially to ens that all local govermmnts, regardless of their fiscal capacity,provide a similar level of certain specified public services to their residents. The idea is simply to set the pQce ofthe service (1-m) to each local goverment in such a way as to neutrlize difference in capacity by varying thematching rate (m). Th higher the income elasticity, the higher the matching rate needed for low-income recipients(to offset the higher local expenditues on the aided sevice in higher-inokom areas), and the higher the priceelasticity, the lower the matching rato needed to achieve a given level of total expenditures. In practice, there isthus a case for varying matching rates inversely with income levels even when only the incenutive offcts (and notthe distributionad effects) of matching grants are considered.

183. Unfortunaely, neither thoory nor available empitical studies provide clear guidelines to determine theprecise matching rate appropriato for particular expenditure progrms, lot alone how those rates should be variedin accordance with the charcteristics of different local governments. Nonetheles, a possible approach might beto consider the matching rate for each progrnm as having two components. The basic matching rate for eah servicewould then reflect the degree of centrl goverment interest in the provision of that service whether that interestis motivated by concem over spillovero, the *merit good natre of the activity, or simply the desire to implementsome plan). This basic rate could then be increasod inversely to a uniformly determined measur of capacity. Thmatching rate faced by any particular locality for any particular prgram would then be higher the greater the degreeof central interest and the lower the (expected) degree of local enthusiasm (price-elasticity) and ability (income-elasticity) to support that progrmL Though data limitations mtn that such refinmets are most unlikely to berelevant in any transitional economy for many years, these principles should nonetheless be kept in mind indeveloping an intergovernmental trasfer system - or any system of subsidized municipal credit, where exactly thesame considerations are relevant.

Other Obiectives of Transfers.

184. In addition to the economic ar _ments for transfers discussed above, there are of course also importantpolitical arguments for transfers in all countries:

* It may be necessay, for example, to transfer some resources to jurisdictions that do not, strictlyspeaidng, need them in order to make it politically feaible to transfer needed amounts to otherjurisdictions.

* It may also be essential to transfer resources simply in order to keep some economically non-viableloc,t govenmments (eg., small riral governments) alive for political reasons - to salvage regional pride,to provide jobs for local supportes, or for some other mason.

In both these cases, the main design problem is to minimie any collateral damage to the presumed economicobjectives, both by achieving the political ends in as cost-effective a way as possible and by trying to ensure thatthe design of such transfers offsets the good features of other trasfers as little as possible.

185. In summary, the main substantive aim of a well-designed transfer program is to 'get the prices right' inthe sense of facing local decision-makers with the full consequences of their actions. The first step in getting theright incentives from intergovemmental transfers is, as argued ealier in this paper, to establish the local publicfinance system itself as much on a benefit basis as possible. Ideally, local own-source revenues should come entirelyfrom local taxpayers. Local governments should not have acces to taxes that they can export to non-residents(except to the limited extent such taxes may offset the provision of local public goods that lower production costs).

5ss -

A Caso for Conditionaliq?

186. Given such a system, the next step is to tecogpi that (in a non-fedral systm) local auorities mustfundamntally be responsible to the ceaml authorities or, mor accuatly, to taxpyers at Inrge, when they arespending cental funis. Ther is thus il prnciple little role for completely unconditiona trnfe - except,perhaps, to the extent that such "tnsfers are not really tuane at all but rather simply centm ral for locally-executed central prjocts or else result from centrl colloction of local taxes (for example, because itwould not be cost-effective to set up separate local tax adminisratons). Since any other unconditional transfen inthis system are essentially motivated by politics, the concern these case is primaily to limit the damage doneto policy outcomes - for example, trnsfer. that simply finace local deficits or that age entirely disretionay innaure are invariably bad.

187. On the other hand, transfers intended to encourage "rending on a specific local service, whether becauseit generates exteanlities or because it is more efficient to a -- 'he service locally, shutld genenrly requiresome local contribution (matching) and should of course be cono..Aonu on the performance of the service in questionin accordance with specified standards.A' Both the detemination of the appropriate matching rates and the extentof central support and monitoring of local performance (see also the ealier discussion of this subject) require closestudy with respect to each substantive area in which such grnuts (or their analytical equivalent, subsidized loans)are to be established.

188. So far there appears to have been little considertion in the trasitional economies of what would appearto be a strong case for some degree of conditionality in centa transfers. In Hung=v. for instance, which has byfar the best-developed transfer system, the normatve gnat has three important charactiics. In the first place,the total to be distributed to local govemments through this grant is tirely discretionary. Secondly, the fomulafor distributing this total in turn contains two components. The first conponent, which may be thought of as theequalizion component of the grnt, is essenially an equal per capi tranfr. Tho secwod, and lager, part of thegrant, however, is distibuted basically in accordance i largely based on a mease of expecdituro needs',particularly with respect to education. Finally, the grant is completely unconditional: local govenments can spendthe money however they see fit.

189. In principle, there seems little rationda for bestowing such large unconditional grants on so many smalllocal goverments. As with some other featues of the Hungarin local govenment finance system, it appears thatthe understandable desire to reject completely the centrally-dominated model of past intergovemnmenal rlations mayhave resulted in, so to speak, throwing out the baby with the bathwater. The centrl government - that is, taxpayersin general - have a legitimate interest in what is done with grants to local govemments. Moreover, the country asa whole also has a legitimate concer to ensure that services such as education and health are available throughoutthe country at least at minimum standards. There is therofore a strng case for at least limited conditionalit, forinstance, by requiring that the grant funds should be spent on e.g. education or hellthU' or requiring localgovemments receiving such grants to provide services of at least a specified quality and level.

LNo matter how closely supervised, the inherent fungibility of financial transfers means, of course, that there isno guarantee that conditional tr usfers will not in whole or part simply replace locally-financed expenditures thatwould have been made in any ca . On the other hand, the available empirical evidence in a number of countriessuggests that to at least some extent conditional funds do indeed astickl, that is, result in an increase in totalspending on the aided function.

Wlof course, such legal requirements are inevitably to some extent only pro forma. The fungibility of money andthe ability of local governments to alter other expenditures and taxes mean that requiring a grant to be spent on aparticular activity does not necessarily imply that tota1 (centrally-finded plus locally-funded) expenditure on theactivity has gone up proportionally. Indeed, in most cases it will not.

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190. Compliance with any such conditions could be monitored, as suggested earlier, through requireme foruniform and timely local financial reporting and tirough periodic national inspecdons and audits of local facilities.Although tn the current situation in Hungary it is probably politicaly inadvisable to alter the present unconditionalityin any important way, at the very least the national govenment should make evely reasonable effort to improvelocal financial reporting - for example, making the provision of such reports a condition for receiving grants - aswell as attempting to improve its information basn on what is going on with respect to the provision of local publicservices.

Deterininnin the Size of the Ora.

191. Another feature of the normative grant that requires further consideration is the determination of the totsize of the grant. At present, this determination is in effect entirely up to the central govemment. While budgetayflexibility in this respect is obviously desirable from the centrl goverment's short-run point of view, it is a mistaketo view cental transfers to local govements as constituting an entirely 'compressible' portion of the nationalbudget. On the contrary, many of the services provided by local govenmments constituto essential inftucture forfuture development. Moreover, since it is unlikely that most of the small local governments created in Hungarycan ever finance the provision of such services at an adequate level out of their own resources, either now or in theforeseeable future, centrl grants to local governments will remain an important, and largely non-compressible,expenditure item in the central budget of Hungary, as of most transitional countries.

192. In these circumstances, there may be much to be said in favor of establishing a formula-driven total e.g.as a specified percentage of national revenues or of some particulr national tax or taxes. This procedure hassubs antial advantages from the point of view of both centra and local budgeting. Since the amount of the localtransfer is determined, the central govermment is to some extent insulated from pressure to increase it support oflocal govenments. On the other hand, local governments can budget with much greater certainty when they knowthat the total level of central support wiU vary with e.g. income tax coUlections (distributed in accordace with aknown formula) than when they are totally at the mercy of discetionary contral policy. Again, in the transitionscialist economies, the grants are typically fixed in an ad hoc way, both in aggregate volume, and in terms of theallocation across individual governent units, which are negotiated and bargained between center and locals.Hungary is the only exception here: the grant volume is detemined annuaUy by MOF, but its allocation is by acomplex (some might say overly complex) formula. This complexity can be explained in part as a reaction to theimprecision and bargaining by which the previous allocation system worked: over-precision is an attempt to moveas far as possible from this approach.

Distribution of the Grant.

193. However these two points - the unconditienalitof the grant and the determination of its total - are settled,the distributive formula of the grant also needs to be addressed. As noted above, at present there are two elementsin the present Hungarian formula: equalization (per capita) and needs. As agued above, a third essential elementin any general grant formula is to make some explicit allowance for the revenue-raising capacity of localgovernnents. That is, the basic formula of the normative grant should be altered to some version of the followinggeneral formula:

Gt = eE1 - tRl

where G is the amount of the grant, i refers to a particular municipality, E to some measure of 'need' (for example,the present normative grant formula, population, or anything else that seems appropriate), e is an assumed level ofexpenditure for each unit of measured need, R is a measure of revenue capacity, and t is the assumed rate at whichthis capacity is tapped (or taxed).

194. Asuming for the momentthat the tota G to all i is equal to the prest normative grmt and t the'needs" measure is that used in the present formula - as noted earlier, both of these assumptions can be changed

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in any desired way without affecting the general argument! - the introduction of the capacity element has threeimportant effects. First, it will shift grant funds from high-capacity to "low-capacity recipients. Second, it willstimulate all recipients, regardless of their estimated capacity, to tax that capacity at the assumed rate (for example,the national average rate), because if they do not do so, the gant they receive will be reduced precisely by theamount they fall below the assumed rate. Finally, on the other hand, if any recipient chooses to levy higher taxesthan those assumed in the grant formula it gets to keep all the extra revenues - that is, it is not 'taxed by havingits grant reduced.

Measuring Canacit and Expenditure Need.

195. Clearly, the most critical element in this formulation is the measurement of capacity and need. Suchcalculations are difficult in any circumstances and perhaps particularly difficult in the changing circumstances ofthe transitional economies. Nonetheless, some relevant information exists: for example, on collections from the oldduties, on PIT liabilities, and on the 'turnover' basis for the business tax. Moreover, there appear to beconsiderable information in some countries - notably Hungary and the Czech Republic - on the basic characteristicsof the new local governments: their population, its demographic characteristics, their economic bases, and so on.It should therefore be possible to construct a number of estimates of revenue capacity (defined so that the estimateis not subject to local manipulation)W' and expenditure need in order to experiment with variations of this formulaand to determine whether the resulting distribution of the gant makes sense in light of needs and the aims of thenew local finance system.&

196. In contrast to the relatively well-developed Hungarian grant system, in Ro for example, the presenttmnsfers to local goverments are entirely discetdonary and negotiated. The same is true of Russia, and most ofthe former union republics, now the CIS. On the other hand, like the Hungarian case, this transfer appeas to belump-sum, that is, it would appear that local govermets can spend it, once they get it, free of all conditions andconstraints. In fact, however, as under the old regime, the local branches of the Ministry of Economy and Financecontinue to supervise the implementation of local budgets closely and to make sure that the targets specified in localbudgets are achieved. Most of the transfer has in recent years been used to cover the losses incurred by the regiesowing to the large heating and transportation subsidies. In 1991, for example, these two subsidies accounted formore than 32 billion lei out of a total transfer of 65 billion lei. By September 1993, however, these two subsidiesare supposed to be gradually phased out, folowing a 25% subidy cut on May 1 1992, and similar cuts onSeptember 1, 1M, May 1, 1993 and September 1 1993. Coreponding to the cut in subsidies, the cental trnsferto local govemments will appatly be cut proportionally, although that this would happen was by no means clearto some local govermment officials.

197. The basic criticisms that may be made of the present transfer system in Romania (and other countries aswell) are thus three. First, it encourages recipients to be wasteful and lax - and thus run bigger deficits and getbigger transfers. Second, the system may of course also be criticized for its lack of transparency and for theconsiderable amount of negotiation that may (at least potentially) be hidden in it. Third, even if these defects werecorrected - as they largely have been in Hungary - it would basically deliver funds derived from taxpayers in general

tihe same is true with respect to the expenditure level per unit of measured base: it may, for example, be takenas the average national level of expenditure on the chosen item, or as some desired or minimum level ofexpenditure.

LwNote that the estimates of tax capacity required for implementing a grant formula such as that suggested in thetext are estimates of the ability of localities to raise revenue and not necessarily estimates of the ability of localresidents to pay taxes. Both the wrichness' of the locality relative to others and its taxing power are critical to suchcalculations.

EFor preliminary explorations along these lines, see Bird and Wallich, 'Financing Loal Government in Hungary.'

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to officials in particular localities to spend as they see fit, thus vitiating the essential democmtic (and efficiency)principle of accountability.

198. In eality, of course, the existing Romaian systm offers almost no room for local incentive effects sincein fact it is still the old central control system in a slightly different guise. That is, instead of unconditional transfers- set in some undetermined but apparently 'gap-fllling way - in fact up to now local govermnrets have (regardlessof what the law appeas to say) acted as though their expenditure too wern fixed (e.g. with respect to sali,number of employees, levels of services provided, and so on). If the level and composition of local expenditureis, de facto, deUmined centrally, it doss not matte that the level and composition of local revenues is similadydete_rmie there is no effective local autonomy. As such autonomy begins to become real, however, and tbhois evidence that this is now happening in at least some are of Romania, the bad design of the present trassystem will become increasingly unsatisfactory.

199. For this reason, it is important that the future development of tansfers in Romania (and other trnsitionaleconomies) should take more explicitly into account the basic principles of a good transfer system. For exaple,the size of the total transfer to local govemments from th centrl govemment (the Adistibutable j2jgk) might beset as a fixed percentage of totd central taxes. This is desirable to provide both budgetary stability - to insulate thecentral budget to some extent from local problems and to provide a *hard' budget constraint for local governts -as well a sufficient budgetary flexibility over time to accommodate the reasonable growth of local finances.

Moreover, experience suggests that it may be preferable to set the size of the *distributable pool' with referncto all taxes rather than as a percetage of a particular tax or taxes in order to avoid distorting central tax policydecisions.

200. In addition, as suggeted above, the distibution fbEnulshould in principle be based on some feasible, andacceptable, measures of a aciy nd necd and the transfer payments should be made conditional on performance.Although in the end the extent to which any transfers are equalizing' in any country is inevitably essentiallypolitical, it is critical to have an adequae quatitative base in order both to be able to design such equalitionfeatures propedly (e.g. with respect to mathing grants) and especidly to assess their probable effect. A criticalresearch need in most transitional economies is therefore to derive such measures of capacity and need and todevelop a system for monitoring performanc. Close attention must be paid to the supervision, acounting, andmonitoring of trnsfers, and associated local expenditurs. This question is also important with relation to both localborrowing and any use of matching funds e.g. for investment purposes. As noted earlier, a transfer fomulaproperly designed in terms of needs, capacity, and performance will also encourage local fiscal efforL Finally,although for political reasons, it may prove necessary to bas distribution in part on derivation or to make thetransfers payments partly or wholly unconditional, it is essential from the point of view of both efficiency (inresource allocation) and accountability (in public sector decision-maling) that these elements be minimized.

VII. BORROWING

201. In most transition economies, a striking feature of subnational finances is the generous legal access ofsubnational governments to unlimited borowing, sometmes even foreign borrowing. In Hungary, the Local Self-Government Act penrits unresticted domestic borrowing (for current and capital expenditures) to aU localgovernments. In the Russian Fderation, the law on Rights of Local Self-Govenment permits the same for oblastand rayon level govemnments. In Bulgara, the municipalities can borrow from banks, and in addition, under theexisting law they have an unrestricted right to issue bonds. In Poland, borrowing authority is more limited: by law,localities are not allowed to bonrow more than 59% of current budgeted expenditures. In Romamia, localgovernments can borrow in unrestricted fashion, as an element of their *autonomy", provided they can prove theircreditworthiness and amortization capacity. In China, provincial govemments have until recently had unrestrictedaccess to foreimi borrowing through provincially-owned development banks,; this access has recently been teducedthrough a new law on foreign exchange management and debt registration. Local govemments in China cannot

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borrow domestically, however, at least directly, although they do so indirectly through enterprises they own andthrough local financial intennediaries which float bonds designated for local government projectsaL'. In the CSFR,the two republics have restricted access to borrowing through T-bills issued on an agreed basis and amount by theFederal Ministry of Finance. By and large, however, despite these liberal provisions, local government borrowinghas so far not been significant, as table 9 shows.

Eat Borrowing Practices.

202. In some countries, however, the heritage of debt from the previous regime has become a problem. In thepre-reform situation, in which the national credit plan was designed to finance investment and other expenditurescalled for in the Plan, to the extent that in the unified framework of the Plan, local governments required loans,borrowing was not only permitted, but indicated. Th loans wero made by one or another of the State Banks, whoselending was wholly plan-directed. In Hungary, for example, my localities borrowed under the credit pla in thepre-reform period, with each loan being guarnteed by a higher-level authority. In the Slovak Republic theind_btedness of the local (municipal) government to tho banking sector is espocially high: some 30 municipaitieshave been able to pay neither principal nor interest on these loans. In Poland, it has been reported that almost 900geminas (40% of all local governments) are in debt, as a result of borrowing, mainly from banks, under the pre-reform regime.

203. The facilities for borrowing provided to local govenments in the post-reform legislation thus have rootsin the planning period. In present day circumstances, however, such generous and virtually uncircumscribed accessby local govemments to loan finance seems out of place. Such acces is restricted even in most western countriesfor several reasons. First, the centrl government uses debt finance as a stabilization tool, and it does not want localgovemments acting in such a way as to cAmntor its policies. Second, local borrowing may in some cirumstancescrowd out private sector borrowing which may be more economically beneficial to the country. Third, to the extentcentral govenumnts wish to avoid local govemments becoming bankrupt they in effect implicitly guarantee localgovenmuent debt, so that local governmnt borrowing becomes a potentially open (and destabilizing) door to thenational treasury.

Table 10Subnational Goverment Borrowing

Country Local Borrowing Authority Borrowing % of totalrevenue in recent years

Hungary Yes (unlimited in law) some municipalities havepast debts

Poland Yes (limited in law) 1.4%Romania Yee" N.A.Bulgaria N.A. N.A.Czechoslovakia Yes significant past debts

____ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ O Utst nding

Russia Yes (unlimited in law)f' 'China Nay 0Vietiam N.A. N.A.

Notes: [/ Even though local govemments in Romania are pemitted to borrow in principle, in reality ther existsno borrowing -just arrsea (non-payment of bills); 21 This was suspended in 1992; 3/ Sometimes borrowing takesplace through enterprises (see text).

IL1See 'China: Revenue Mobilization and Tax Policy', World Bank Country Report, Washington DC, 1990, and-China External Trade and Capital, World Bank Country Report, Washington, DC, 1988.

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204. For these reasons in virtually every developed country local government access to capital markets is strictlycontrolled. Among the methods used to control local borrowing are: (i) permitting borrowing only for approvedcapital projects; (ii) requiring prior approval of local taxpayers for borrowing above a certain amount; (iii) requiringprior approval of central authorities for borrowing; (iv) restricting the amount of debt to some percentage of localrevenues; and (v) permitting borrowing only from a cental mnunicipal fund.' All such restrictions obviously reducelocal autonomy. On the other hand, it is also common to provide some capital assistance to local governmnta, inthe form of matching grants (as discussed earlier) or in the analytical equivalent of explicitly or implicitly subsidizedborrowing conditions.

205. The precarious macroeconomic situation in many transitional economies malkes the case for limiting localaccess to capital markets even stronger than usual. Additional reasons to be concerned with problems that mightarise because most of the new municipal governments have no experience with financing and are in many instancsnot yet capable of preparing and presenting complete and meaningful projects. Nor, for that matter, are most ofthe financial institutions in transitional economies capable of evaluating long-term risks or hantling long-temfinancial instruments.

206. Nevertheless, to the extent that benefits from some projects are enjoyed in the future, it seems both fairand efficient that future residents share in the cost of financing such projects. Borrowing for local capital projectsmay thus have a sound theoretical base. Moreover, borrowing may someedmes be the only practical way to financelarge capital outlays without huge, and undesirable, variations in local tax rates from year to year. There is thus,in principle, a strong case for financing capital projects at the local level through debt finance.

Sources of Borrowin .

207. In the short term, however, there should probably be imited or no local borrowing in most sucheconomies for macroeconomic reasons. In the longer run, however, some facilities for limited sub-nadonalborrowing will be needed. Long-term borrowing by local governments should be restricted to the financing ofcapital projects, perhaps with regional goverments and large cities having a little wider discretion in using debtAt all times, borrowing from the central bank should be prohibited.

208. A common view in some of the transitional economies appears to be that local governments should betapping the financial markets for capital funding, thus serving the dual aims of developing capital markets andfinancing long-gestation projects. However, only the very largest such govemments are ever likely to be able toaccess financial markets directly. M.'oreover, only in the U.S. are financial markets the major source of debtfinance for local governments. Commercial banks are a more likely source of funds in transitional economies - andthey may well reman the main source, as in Germany. Bond issues might come later, if ever, once markets for suchfinancial instruments are developed, and sub-national governments establish creditworthiness.

209. For most local govermments, however, the only way to access capital markets may be through some suchdevice as municipal development banks, especially if they are not set up by the central government, but spring upas cooperative efforts of, for instance, groups of cities. Such banks (or funds) could give technical assistance tothe individual govermments in this new field of borrowing, would take up deposits from them and lend them thenecessary amounts. Local govermments should not, of course, receive subsidized credit through any such source(except when the national government explicitly wishes to subsidize particular types of municipal investment, forreasons similar to those discussed earlier in conjunction with matching grants). In view of the tangled relationsbetween governments and enterprises discussed elsewhere, it is equally important that such credit not be extendedindirectly through borrowing by goverrunent enterprises.

210. The history of special MuniciRal Develooment Fundsa in other countries is in some respects not veryencouraging (Columbia is an exception). Few of these funds have developed a capacity for sustained (continued)

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assistance to municipal goverment and investment on the scale needed.9 Most have been undercapitalized. Asa rule, they have tended to play a narrow and passive financing role, applying little technical or financial appraisalto the schemes they have funded, and offering little positive assistance to municipalities other than capital finance.Those designed to provide technical assistance have tended to concentrato skills and resource on the direct executionof capital works, which are handed over to municipalities for operation and debt service. While this apprch hsadded to the stock of urban infiastructure, it does little to promote the capacity or commitment of municipalities tooperate or expand that infatructuo effectively, or to recover costs. Too many municipal development fmdas havetolerated substantil arars, with poor repaymnet records leading to weak institutins and incentives for localitiesnot to repay. For al thm reasons, are must be exercised in sotting up specid municipal financing institutions intransitioald economies.

VIII. PRIVAT[ZATION AND OWNERSHIP

211. A striking feature of the fiscal landscape in the transitional economies in the continued significant owne_ iprole of subnational govemments at a tirm when center/national priorities support privatization. One reason is ofcourse the transfer of assets to them in the process of 'decentrlization of ownership described earlier. Anotherreason arises in some degree fom the inadequate revenue base given localities and their continued financialdependance on enterprise revenues. If the privatization process is to be completed, getting local govenments outof business, and into the business of government' is crucial. In the course of this process, important quetionsremain to be answered, relating to the use of the tmnsitory revenues from privatization, and how best to takeadvantage of the asset stock held by local governments.

Asset Transfers

212. One of the most important initial features of fiscal denalizaton has boen the transfer of asset to locagovernments. Local govenments are increasingly becoming owners of enterprises, housing, vacant uban land andretail establishments, as these assets are transferred from the center. In Hungary, the 'Act on Property Trnsfer'(1991) gave local govemnments ownership of the housing stock previously owned by the central governmmt. InRomania, local governments have been given all fonnerly 'statew (centrally) owned properties within theirterritories, ranging from public doman ptoperty (parks) to private domain propetty such as enterprises. In Russienterprises have long been owned by each level of government, and housing and land has been transferred tomunicipal and rayon level governments beginning in 1991. In China, decralization of enterprise ownership fromthe state to provincial and local ownership was a key feature of the overall decentalization of economic decisionmaking, and took place as early as the mid-1980's. Housing has always been a municipal or enterprise responsibility(See Table 10).

213. Such asset transfers can be a mixed blessing. While consistent with decentraliation and rhetoric about localautonomy, such transfers also fit with the center's aim of reducing its involvement in the economy. Indeed, onemotivation for transfers of enterprises, land and public housing, has likely been to avoid the fiscal burden (such assubsidies, maintenance and repair) that ownership responsibilities carry. Local governments wiU thus be fhced withthese major maintenance and subsidy burdens, unless costs can be quickly recovered. Privatization of the houwingstock in particular is a priority (see discussion below on timing of sales) as is sale of locally-owned enterprises.

42/ See Ktn Davey, 1990; Municipal Development Funds and Intermediaries"; PPR Working Paper No 32; WorldBank

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Table 11Privatization Revenues: Ownehip and Disposition

Recent Traosfers of Ownrshp

Country Housing Reail Units Domstic Industrial_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ E nterprises

Hungary Lal Local Centrl, LocalPoland Local. LoAM Central, Lca

Romania _Al _ _ caW_ CntUrl, Local

Bulgaria Local I/ Locale Centratl, LoA

CSFR Local LOc Cental, Local

Russia Local,Enterprise LoLcalChina Local,Enterprise Local, Central Contl, Local

Vietaln Lcal,Enterprise Local, Central Centrl, Local

Notes: In Bulgara only Q-T1 t of th tothlc s ot local authoriies. l he r85-90% is now privatey owned.; * almost exclusively local.

Privatization vs Entmreonoeudlism

214. Unforuately, in at least some countries just the opposite appa to be taling place. There is conidebleevidence that this process of proprty transfer is giving broader scope to thoe enrpreneulal ambitions in the localgovernments as they use their now property rghts to activateo idle property. A womsomo patten in vituallyall transition economies has been the involvement of governments at different levels in joint economic venure ipurely private maket oriented activities. Romania's law puts it best, but is not exceptional: * Local gove m_Uare authorized to rerae, contrbute equity and or take shares in commercial enterprises formed with their assetsbelonging to or transferred to their ownership, including the possibility of forming joint ventures with foteign ordomestic parlners.

215. Localities appear to be excessively optimistic about their abilities to enhance reveaue from this source.One vehicle some hope to use is to establish joint ventures with a domestic or foreign parbter, or nothr stateenterpise, using local assets as the locality's equity share. In those localities well endowed with land, ths appeasto be the preferred equity contribution, and loclities appear also to see potential in developing and seiricing emptyland so as to enhance its value as equity. Of course, real estate development and financing is of course One of theriskiest business areas in maket economies, and it is not likely to be a better bet in the transitional economie. InHungary, toursm lodges, recreational facilities and golf coures were cited as examples of such venturesin-process,and in localities which inheited important real properties similar potential was sen in developing thom ascontributions to industral joint ventures such as bakeries, construction firms, and food processing. In Russa,virtually all rayon governments visited in the course of field work indicated the noed to develop and exploit theirasset base through domestic joint ventures, and looked forward to the revenue flow from the projects, onecompleted. Similarly, in Poland, the provision of private services as a means of eaming additiond revenues apperto have strong support, with housing and real estate development, food and furinitu manufacure cited as exampls.

216. From the prspective of locd government, there are good reasons for government involvement in thesenew market ventures. With available land that can only with difficulty be privatized, the cost to govrment ofcontributing this resouce to a joint venture may be perceived as very low. Also many local public officiasunderstandably wish to create buiness employment opportunities in their jurisdictions, which are often oca'omically

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depressed and lackng privao e preneurship.0 However, tho hope for profits from such ventur my quicklytum into demnds on govemmet budgets to cover losses. Experience everywher shows thtu the perspectives andgoals of public officibl tend to Make them poor busins managers. In piculr, it is very hard for a govrnmtto close a faling bum, especiay whe the local mploqynt iSaion is fa from halthy. There is also the riskthat the local govaunat ald their locallyownd businesses wll udcut privat competitors, possibly by playigrogulatory pmes to protect locd monopolies, with the reoult t te trole of govement in the econmy will notdiminish. And, of course, if local governmen own busines, thy may fail prey to the ridsk of ownerhip. Inthe indusil market economies, te rats of small busine failu is high: only on in five of such businssurvive their first three yea. Thee is no ran to expect tt the tranitionl eonomies can beat theom odda.

217. More impotty, in addition to being ddy, rur activity by local goveanmt is fundaimayinconsistent with the privatiuon drive, and reprets a bottteck to tnuo denrl o-that is, d aliton,not from the state to local govenments, but fiom govenment to the private octor. Local etrepreneuria tyis neither privadtiaonnor tru de ition.Suchb entrdeuaiaHsm sows down even reverses, tho prooeof privatization - the long-term goal of getting govenmt out of toe activities that can be handled by the privatesector.

218. It is thus critical in reforming socilist economiae to provide adequa revenue instruments and flexibilityat the subnational level. If the only flexibility available to local govermnts in their stuggle to cope withbudgetary pressure is by using economically undeirable sources of revenue such as profits derived frm directpublic ownership of local busnes, thy will do so. Municipalities should not be encouraged to develop localmonopoly enterprise in order to secure the revf A they need to function, just as they should not be forced toestablish small taxes on a wide nmre of proutsb and activities which ae expeive to adminise, genatewidesrad public ressnc, and typically yield littlo. Some local aconss to a robust national tax base (troughtansfers), the ability to levy local surcha on ctai national tax whero approprate, and especlly somesignificant rvenue sourcs under Ilocal control are thus essential, if the struggle for local revenue is not to delayand perhaps dstroy prvatization reforms.

Timine of Asset Sales: Sales vs Give-wava

219. Potentially, selling the assets (housing, entorpdses, land) held by local govemments could yield syigficatevenues. There is, however, considerable controversy over how this procoss should take place, and even overwhether assets should be sold or given away. The metods being employed in diferent countries range fomauctions to 'spontaeous privatztion' to voucher systm In mxst of the countris under study, at the local levelassets are being sold, not given ay: In Hunguy, such are th responibility of the Stato PrpertyManagement Company (for large enteprises). For smal entepns as wel u locally owned houing, in bothHungary and Polsnd, local governments have responsibility. In Russi, the housing stock and locally-owned factiesare a subject to sba. CSFR's privatization prognm combines give-aways (through vouchers for aU citizens) withrevenue-generating sales. Most enterpis will be sold by the two republics; the role of the local govemmontswithin theso republics is not clear. Bulgada, and Romunia have yet to devise concrete privatization progams, butthey are likely to include both give-aways through vouchs and sales.

220. Maximining the yield from asset sales isa major challeng. Should they be sold now or later? Sellingassets now, when markets for ownership and prperty rights are underdeveloped, may mean that they do not bnoga good price for the local governm t - a process, as oam analysis put it, akin to using the beat furnitur to uWel

!WA note of caution is also needed with repoct to the apparent desire of many local govemments to use fiscalincentives to bolster private business in their judsdictios. he record of such 'local development policies is notvery encouraging in any country, and efforts in this direction are all too likely to degenerate into a zero-sum gamefor local governments unless great care is exerted. On the whole, this is yet another ares in which a national'fnmework law- - a binding cael arrangement - seems needed.

- 64 -

the boiler on a ship running out of fuel'. But at the same time, government needs revenues now. Selling aMlater may improve yields, but such yields will come at a time when other local financing sources will also beavailable. Complicating this decision is the fact that many locally-owned properties are presently costing much moreto operate and maintain than they are realizing in rents an, hence constituto a major drain on subnational publicfinances. Getting rid of this burden is a high priority. Unfortuately, in almost all countries, the pocem of saelinglocally-owned enterprises, and especially housing, is slow, impeu by the absence of credit (especially mortfinance), and the absnce of a legal framework.

Revenues from Privatization

221. What should local goverments do with the proceeds from the privatization of public enteprise and tdosale of other assets? First, it is importnt to remember tha hes rvenues are 'non-recurring' and do not rpretpermanent sources of financing for any local govemment Efforts thus have to be made to develop adequae txsources in addition to user charges for the future, when the revenues from asset sales disappear. That said, shouldsuch asset revenues be capitalized in special funds or invested on capital projects, or should they be used to financecurrent expenditures?

222. In practice, there appear to have been no special strings attached to the use of revenues from privatization.Te unsurprising result is that the most common practice appeass to be the use of these funds as an additional sourceof revenue in the recurrent budget. This is not all bad: indeed, it may be both distributily attractive as well economically efficient (less dead-weight loss) to raise revenues from privatization than from taxes. But, as notedearlier, one cannot live forever by selling the furniture. Sometimes such revenues have been kept in exrabudgetayaccounts. in Hungary, for instance, rents from locally-owned housing accrue to off-budget accounts, while slesproceeds from locaUy-owned housing accrue to the general budget, but are not earmarked for any partculwrpurpose. In the case of privatization of locaUy-owned enterprises, the proceeds also accue to the budget, with norestctions on use. In Poland and Russia, revenues accrue to the budget, with no restrictions on their use.

223. A more conservative principle of public finance would cal for the investment of these proceeds in long-term assets to alow local govenmerts to draw income from assets over a long period of time. Altenatively,revenues could be used to repay debt.44 In Hungary, revenues from privatization involving foreign joint ventrand generating foreign exchange are channeled through the State Property Management Agency (SPMA) to repayHungary's external debt. In the Russian Federation, where most privatization has been domestic, it has beenrecommended that the stock of domestic govemment Treasury debt should be reduced this way. In Poland, revenufrom privadzation are being used to finance current operations, and to compensate for inadequate tax yields. InChina, no commitment to privadzadon is as yet apparent.

IX. CONCLUSIONS

224. Subnational finance and local government policies are emerging as crucial elements of the ongoing reforsin transitional economies. Subnationai governments play a large role in overall economic activity, account for alarge share of public sector outlays, and own a significant share of public enterprises and the public housing stokRecent attempts to strmlne government budgets have led to increased local government responsibility for suchcrucial matters as health, education and safety net expenditures, including unemployment and entepis.

X'See Newbery, D. 'Reform in Hungary: Sequencing and Privatization,' E Economic Review. No 35, 1991,pp 571-580. Newbery argues against a rapid, 'fire-sale' or giveaway approach becas many of the assots mayhave been financed with debt (as noted earlier, many local govemments in transitional economies have substantialliabilities), in which case the proceeds should be used to pay off this debt, rather than burdening preset and futurelocal taxpayers with debt service.

- 65 -

Underfimded local govermments arn seleing coping mechanisms, not all of them constructive, to meet these newchallenges.

225. This paper has descibed the risks to privatizaon, to macroeconomic stability, and to an adequate socialsafety net that present policies towards local governmnt may imply. Our themes are that the subnational sectrneeds to be m realistically factored into national plans, and that subnational expenditures be more clearly aignedand revenue needs more realisticaly aessed. Such _ are likely to acknowledge * larger sphero forsubnational govermments and the need for access to more robust revenue sourcs. Giving local government a dsrein the personal income tax is one possible and perhaps desirable approach to meeting these revenue noeds.

226. Careful attention also needs to be paid to the desip and implementation of toe intergovenmental fisatransfers that are likely to remain prominent features of the intergovermental landscape for years to come. Cautionis also needed with respect to borrowing by subnational govemment Consolidation and integration ofextrabudgetary funds at the subnational (and national) levels is crucid to enhanced budgetary transparency andmacro stability.

227. Finally, proper funding of the subnational sector is a necessary (albeit perhaps not sufficient) condition forthe successful privaization of enterprises now held by local governments. In its absence, local goveanments willcontinue, as at present, to seek gains from keeping these enterprises, and to add to their revenues by setting vp newcommercial enterprises and impeding privatization.

228. In short, local govemment finance is not a 'local matter', but is crucial to asmost all of the key reformgoals of stabitization, safety net and private sector development

- 66 -

APPENDIX TABLES

GOVERNMENT REVENUESROMANIA 1991

Capital Revenue 0%Nontax Revenue 2, Ta Revenue 27%

Capital Revenue 1%Nontax Revenue 2%

Tax Revenue 97%

Subsidles 8 Grants 71%

Local Government Revenues Central Government Revenues

LOCAL GOVERNMENT EXPENDITURES BY TYPEROMANIA 1989 and 1990.

Education 35%Educatlon 5% Rec. Cult. Religlous 4%

Health 11% General Pub. Service 6%Soc. Securlty & Wel. 1 re. Cult. Religious 3

Housing & Commun. 11% Soc. Security & Wel. 2 % General Pub. Service

Other Expenditure 1%Other Eco. Affairs 3%Ag, Foreaty. Fish 9% ther Expenditure 37% CY%

Mlning, Manu & Con. 1\ Transport. 8 Com. 10SOTransport. & Com. 8% Housing & Commun. 27% T CnOther Eco. Affalrs 9%

Expenditure by Type 1989 Fuel and Energy 3X g oresty. Fish 11%

Expenditure by Type 1990

Public order & safety, Health andMining, Manufc and Construction hadzero expenditure in 1990.

-- - ---- - ------ ------ ------ --- - --

i t ; e > < g e p " a ^ ;A[U ~- - -- - - - - -- - - - -- - - - - --a ~ ~ ~ ~ ~ A- -e Is _ e ADw~ 0Z 4. N as t a el ?IS F p U AD

. ~ ~ ~ ~ ~ ~ ~ ; ;P ;A DI o4 ow w0 h 8X *ai ------------------------------------ --

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o a8 a 8 8.

a N a a !4 - a N 04~~~~~~~~~~~ '

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k o j j. ^. g e 8 j g u 8Y 8

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0 0 0 5 P P 8 P

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P P P 8 g° P P P 8P P P P P *-s8---------------------------------- 6-_-

-69-

= == = = =O =~ =~ qI *

iw ~ ~ ~ ~ i6 6~~~~S d

to OA S = f rj a:.{1 5p N

w w C w4 - - - -NM d N W CD #A co a o*

a W: 'o W _ _ -

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- --…-- - - - - - - -C-- -

ii ~~~~~~~AA- - -- -O - -a4 r : et e 12 a - ;;a e; s

a~~~~~a- - - - - - - - --- -

si4 a ^ a i i $ s. *

"h AX < <: ". £1t ..... .. - . _ _. e U === ==========================

Xt 66 i j d-Xa~~~~~~~__~ ~ _______ ___d__ ___

I f..Ij R I 42.^ jI ttt # §| 6d ,a 4E UiA .55 R

__E ~ j u I~I ________________ _ __ I! I Si s R

BUDGETARY EXP. AT THE SUBNATIONAL LEVELRussian Federation, 1990

Communal Service 1%Social Welfare 4%

Housing & Utilities 18%

Public Health 43%

Social & Cultufal 57%Other Expenditure 12%

Education 53%Pub. Authority & Ad. 3%

Variou's Complexe 8%

Total Expenditures Social and Cultural Activities

Source: MOF and Bank Staff Calculations

REVENUE STRUCTURE AND REVENUE SHARINGFOR Q1 1992 (estimates) RUSSIA

Value Added Tax 28%Company income Tax 31%

Company Income Tax 13% Prsonal Income Tax 10%

ExcIses 4% Peraonal Income Tax 4%

All Other 9%

Value Added Tax 29% Exciaes 12%Tax on Foreign Trade 39%

Central Government Subnationals

Different values were reported for eachmonth of Jan. Feb and March 1992. Thusestimates should be vlewed with caution.

* AGGREGATE LOCAL REVENUES IN BULGARIA1991 and 1992

shared lothS tEx _1|

shared Income tax 122Own floa-tan revenue SS

OWm source loee ISown property lox IsOwn nonl-tax revenuo IS

shared Income Sax 54,

shored turnover tax OS

shared tErnovet tau Planned

1991 Executed 1992 Planned

LOCAL GOVERNMENT EXPENDITURES - BULGARIA1991 and 1992

social security 105

Medlodamnts 4% Food TO -S

t | i _ ~~~~ivostments 10% _ I_|ISt 1

Oflilo * economic 15s

atti_, a e Economtc 1211 _General Repaia 3% orer 1i RaGnerepair ts Other 1S

1991 Executed 1992 Planned

LOCAL GOVERNMENT EXPENDITURE BY TYPEHUNGARY 1990

Education 42%

General Pub. Service St

Health 6% I!!!l!!rITIIII!fhI_______0_ Other Eco. Attairs OZ

Soc. Security & Wel. 7?

v W Transport & Comm. 8%

Housing & Commun. 11% Ag. Forest'y, Fish 3%Rec, Cult & Religlou 8%

There was no exp. on Pub. Order andSalety. Fuel and Energy, MIning.Menu & Construotlon.

LOCAL GOVERNMENT REVENUESHUNGARY 1990

=ax Revenue 30%

Nontaex Revenues 18%

Copitol Revenue 56 1lnonolng a.._

Orants 44%

Tax Revenue Is only comprised ottax on Income, protit and capitalgains

- 78 -

s 4p w ei e8 8S

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ci - :i sz 3 _.~ I__ _ _ _ _ __ _ _ _ _ _ __ _ _ _ _ _- -- - -- - - C - l -0 - -- -9'- -. - .

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I D e X So 40 4 2 4 g '- - - - --0 ----

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- 80 -

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- -- - - - - - - - - - - - - - - - - - - - - - - - - - - -

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X- a - a - - - - - - - - - o- - - - - -gs ^ us 2S ~ o 8 8 et t a

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- 19 -

- 82 -

i- ___________________________________

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--- __ _ __ _ _ __ _ _ _ __ _ _ _ __ _ _ _

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g ~~~~~~~~ -

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- 83 -

o__ __ __ __ __ ______________ ____

O N .r 2 0 N o. e n 'V n _ o

0:__ __ _ _ _ _ _ _ __ _ _ _ _ _ _ _

- -- -- --PIV _' 4 N O N O1 -g o. _ _I e _

=_=- - - - - --- - - N - .N N -

a~~~~~~~~~ -----

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i - -- - - - -- - - - - -- - - - -

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5 44 4 e. -I n, 0 NI f 'N 0 N I N, _I o o oe, °, °.--- -- - e- - - - -- ----

Ixg~~~~~~~~- - - - - - -° - - - --................. NO OI

-84-

REFERENCES

Bird, Richard, Federal Finance in Comparaive Persgecive (Toronto: Canadian Tax Foundation, 1986).

Bird, Richard, and Christine Wallich, 'Financing Local Govemment in Hungary,' (Washington: World BankWorking Paper No. WPS 869, March 1992).

Bahl, Roy W., and Christine Wallich, -l'tergovarumental Fiscal Relations in China,' (Washington: Wodd BankWorking Paper No. WPS 863, Febmary 1992).

Davey, Ken, 'Municipal Development Funds and Internediaries,' (Washington: World Bank PPR Wo,rking PaperNo 32, 1990).

Go, Delfin, 'Revenue Uncertainty in Transition Ec9nomies,' (Washington: World Bank RPO No. 67718,forthcoming).

Jarvis, Sarah and John Micldewright, 'The Targeti4g of Family Allowance in Hungary,' (Washington: World BankConference on Public Expenditures and the Poor Incidence and Targeting, June 17, 18 and 19, 1992).

Kornai, Janos, The Socialist SN :tem (Princeton: Princeton University Press, 1992)

k4ilanovic, Branko, 'Distributional Incidence of Cash and In-Kind Transfers in Eastern Europe and Russia,'(Washington: World Bank Conference on Public Expenditures and The Poor: Incidence and Targeting, June17, 18 and 19, 1992).

Newbery, David, 'Reform in Hungary: Sequencing and Privatization,' European Economic Review No 35, 1991,pp 571-580.

Shah, Anwar, Pe.rspectives on the Design of lntergovernmental Fiscal Relations,' (Washington: World BankWorking Papor No. WPS 726, July 1991).

Szapary, and Mario Blejer, 'The Evolving Role of Fiscal Policy in Centrally Planned Economies under ReformThe Case of China. (Washington: IMF Working Papor No. 407, 1989).

Tanzi, Vito, ed., Fiscal Policies in Economies in Transition (Washington: IMF, 1991).

Wallich, Christine, 'Fiscal Decentralization: Intergovermmental Relations in Russia,' (Washington: World BankStudies in Economies in Transition, No. 7, forthcoming).

Wong, Christine, 'Central-Local Relations in an Era of Fiscal Decline: The Paradox of Fiscal Decentralization inPost-Mao China,' China Ouarterly (December, 1991).

Wong, Christine, 'Fiscal Reform and Local Industrialization,' Moder China (April, 1992).

World Bank, China: Revenue Mobilization and Tax Policy (Washington: World Bank Country Study, 1990).

World Bank, 'China: Extenal Trade and Capital,' (Washington: World Bank Country Report, 1988).

- 85 -

Notes for Table 3

1. Datd for total expenditure as a percent of GDP was obtained from the Recent Economic Developments of theIMF.

Hungary: SM/92152, March 12, 1992Poland: SM/9l/7O, April 11, 1991Romani: SM/92/96, May 8, 1992Bulgaia: SM/91/52, Marh 7, 1991CSFR SM/92/65, March 23, 1992Russia . SM/92/26, Febnuy 6, 1992China SM/91/17, January 28, 1991Vietnam: SM/91/234, December 5, 1991

2. Expendituie data are for a consolidation of the budget of the cra govemet and the financial operationsof provinces, counties, municipalities and townsips. Extabudgetay financial opaonS of the various lovels ofgovernment are not included. Data is based on budgeted values, not actuals.

3. Data for 1987.4. Data for 1988.5. Data for 1991.6. For 1986.7. For 1992.8. For 1985.9. For 1989.10. 1988 data for the USSR.I1. Data for the first cuarter of 1992, the Russian Federation.12. Data for 1990.13. As % of USSR expenditure; USSR GDP.* Provincial (not local) expenditures.

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